Use of foreign currency options to hedge forecasted foreign sales

Our U.S. company anticipates sales to customers in New Zealand in six months on March 31 that will

be denominated in the New Zealand Dollar (NZD) and are expected to amount to NZD 10,000,000

(these anticipated sales are not firm commitments at this date). We are concerned that the $US may

strengthen vis--vis the NZD during the interim and, to hedge this exposure, we purchase a foreign cur-

rency put option with the following terms:

Contract amount................................... NZD 10,000,000

Trade date ....................................... September 30

Expiration date .................................... March 31 (next year)

Strike price ....................................... NZD 2: $1

Spot rate on trade date.............................. NZD 2: $1

Option premium ................................... $20,000

The option is designated as a hedge of the companys forecasted sales, and we expect that at the hedges

inception and through the date of the forecasted sales, the hedge will be perfectly effective, since the

critical terms of the option contract match those of the anticipated sales.

The spot and time value of the option over the next six months are as follows:

Date Spot Rate (NZD:$US) Time Value

September 30 (this year) .... NZD 2.00 : $1 $20,000 (cost)

December 31 (this year)..... NZD 2.10 : $1 $ 9,000 (assumed dealer quote)

March 31 (next year) ....... NZD 2.30 : $1 $ 0

a. Should we account for this transaction as a fair value hedge or a cash flow hedge? Why?

b. Briefly describe the accounting for this transaction.

c. Compute the options intrinsic value and total value on September 30, December 31, and March 31.

d. Prepare journal entries for the following:

1. Purchase of the option for $20,000 on March 31

2. The change in the time value and intrinsic value of the option on December 31

3. The change in the time value and intrinsic value of the option on March 31

4. Cash sales to foreign customer in the amount of NZD 10,000,000 at the spot rate of NZD

2.30:$1

5. Net cash settlement of the option at its maturity on March 31

6. Adjusting entry to transfer any deferred gains (losses) from AOCI into current earnings as of

March 31

e. Summarize the economics of this transaction.