You are on page 1of 45

# Chapter 27

DERIVATIVES

## Problem 27-1 (IAA)

On January 1, 2011, Pasay Company entered into a two-year P3,000,000 variable interest rate
loan at the prevailing rate of 12%. In 2012, the interest rate is equal to the prevailing interest rate
at the beginning of the year.

The principal loan is payable on December 31, 2012 and the interest rate is payable on December
31 of each year. On January 1, 2011, Pasay Company entered into a "receive variable, pay fixed"
interest swap agreement with a speculator bank designated as a cash flow hedge.

The prevailing interest rate on January 1, 2012 is 14% and the present value of 1 at for one period
is .877. What amount should be reported as "interest rate swap receivable" on December 31, 2011?

a. 60,000
b. 52,620
c. 30,000
d. 0

Since the interest on January 1, 2012 is 14% which is 2% higher than the fixed rate of 12%, it
means that Pasay Company shall receive P60,000 from the bank on December 31, 2012. This
receivable is recognized as a derivative asset on December 31, 2011 at present value of P52,620
as follows:

## Interest rate swap receivable 52,620

Unrealized gain -- interest rate swap
(60,000 x .877) 52,620

## Problem 27-2 (IAA)

Imus Company received a two-year variable interest rate loan of P5,000,000 on January 1, 2011.
The interest on the loan is payable on December 31 of each year and the principal is to be repaid
on December 31, 2012.

On January 1, 2011, Imus Company entered into "receivable variable, pay fixed" interest rate swap
agreement with a speculator bank as a cash flow hedge.

The interest rate for 2011 is the prevailing interest rate of 10% and the rate in 2012 is equal to the
prevailing rate on January 1,2012. The market rate of interest on January 1, 2012 is 7% and the
present value of 1 at 7% for one period is .935.

What amount should be reported by Imus Company on December 31, 2011 as "interest rate swap
payable"?
a. 150,000
b. 140,250
c. 100,000
d. 0

Since the interest rate on January 1, 2012 is 7% which is 3% lower than the fixed rate of 10%, it
means that Imus Company shall pay the bank P150,000 on December 31, 2012 or P5,000,000
times 3%.

The interest rate swap payable is recognized as a derivative liability on December 31, 2011
as follows:

## Unrealized loss -- interest rate swap 140,250

Interest rate swap payable
(150,000 x .935) 140,250

## Problem 27-3 (IAA)

On January 1, 2011, Taal Company received a 5-year variable interest rate loan of P6,000,000 with
interest payment at the end of each year and the principal to be repaid on December 31, 2015. The
interest rate for 2011 is 8% and the rate in each succeeding year is equal to market interest rate on
January 1 of each year.

On January 1, 2011, Taal Company entered into an interest rate swap agreement with a financial ins-
titution to the effect that Taal will receive a swap payment if the interest on January 1 is more than
8% and will make a swap payment if the interest is less than 8%. The swap payments are made at the
end of the year. This interest rate swap agreement is designated as a cash flow hedge.

On January 1, 2012, the market rate of interest is 9%. The present value of an ordinary annuity of 1
at 9% for four periods is 3.24.

On December 31, 2011, what amount should be reported by Taal Company as "interest rate swap
receivable"?

a. 300,000
b. 240,000
c. 194,400
d. 120,000

The interest rate on January 1, 2012 is 9% which is 1% higher than a fixed rate of 8%. This means
that Taal Company shall receive an annual interest swap payment from the financial institution of
P6,000,000 times 1% or P60,000.

Since the term of the loan is 5 years and one year already expired, Taal Company shall receive P60,000
at the end of 2012 and can expect to receive P60,000 at the end of 2013, 2014 and 2015.

Thus, the present value of the four annual payments of P60,000 is recognized as interest rate swap
receivable on December 31, 2011 or P60,000 times 3.24 equals P194,400.

## Problem 27-4 (IAA)

On January 1, 2011, Trece Company borrowed P5,000,000 from a bank at a variable rate interest for
4 years. Interest will be paid annually to the bank on December 31 and the principal is due on Decem-
ber 31, 2014. Under the agreement, the market rate of interest every January 1 resets the variable rate
for that period and the amount of interest is to be paid on December 31. In conjunction with the loan,
Trece Company entered into a "received variable, pay fixed" interest rate swap agreement with another
bank speculator. The interest rate swap agreement was designated as a cash flow hedge. The market
rates of interest are:

## January 1, 2011 10%

January 1, 2012 14%
January 1, 2013 12%
January 1, 2014 11%

The PV of an ordinary annuity of 1 is 2.32 at 14% for these periods, 1.69 at 12% for two periods and
0.90 at 11% for one period.

a. 5,000,000
b. 2,000,000
c. 2,500,000
d. 500,000

## 2. What is the derivative asset or liability on December 31, 2011?

a. 464,000 asset
b. 464,000 liability
c. 600,000 asset
d. 600,000 liability

## 3. What is the derivative asset or liability on December 31, 2012?

a. 200,000 asset
b. 200,000 liability
c. 169,000 asset
d. 169,000 liability

## 4. What is the derivative asset or liability on December 31, 2013?

a. 45,000 asset
b. 45,000 liability
c. 50,000 asset
d. 50,000 liability

Solution 27-4

The "notional" of the interest rate swap agreement is equal to the principal amount of the loan or
P 5,000,000.

The interest rate on January 1, 2012 is 14% which is higher than the underlying fixed rate of 10%.
This means that Trece Company shall receive a swap payment from the bank of 4% times P5,000,000
or P200,000 annually for 2012, 2013 and 2014.

The present value of the three annual payments is P200,000 times 2.32 or P464,000. This amount
is recognized on December 31, 2011 as interest rate swap receivable which is a derivative asset.

The interest rate on January 1, 2013 is 12% which is higher than the underlying fixed rate of 10%.
This means that Trece Company shall receive a swap payment from the bank of 2% times P5,000,000
or P100,000 annually for 2013 and 2014.

The present value of the two annual payments is P100,000 times 1.69 or P169,000. This amount
must be the interest rate swap receivable on December 31, 2012.

The interest rate on January 1, 2014 is 11% which is higher than the underlying fixed rate of 10%.
This means that Trece Company shall receive a swap payment of 1% times P5,000,000 or P50,000
on December 31, 2014.

The present value of the P50,000 payment is P50,000 times .90 or P45,000. This amount must be
the interest rate swap receivable on December 31, 2013.

## Problem 27-5 (IAA)

On January 1, 2011, Camry Company received a two-year P500,000 loan. The loan calls for interest
payments to be made at the end of each year based on the prevailing market value rate at January 1 of
each year. The interest at January 1, 2011 was 10% Fortuner Company also has a two-year P500,000
loan but Fortuner's loan carries a fixed interest rate of 10%.

Camry Company does not want to bear the risk that interest rates may increase in the second year of
the loan. Fortuner Company believes that rates may decrease and it would prefer to have variable debt.
So the two entities enter into an interest rate swap agreement whereby Fortuner agrees to make
Camry's interest payment in 2012 and Camry likewise agree to make Fortuner's interest payment in
2012. The two entities agree to make settlement payments, for the difference only, on December 31,
2012

1. If the interest rate on January 1, 2012 is 8%, what will be Camry's settlement with Fortuner?

a. 10,000 payment
b. 10,000 receipt
c. 5,000 payment
d. 5,000 receipt

2. What amount will Camry report as fair value of the interest rate swap on December 31, 2011?

a. 500,000
b. 10,000
c. 9,259
d. 9,091

Solution 27-5

Since the interest rate of 8% on January 1, 2012 is lower than the underlying 10% rate, Camry is re-
quired to pay Fortuner the difference of 2% times P500,000 or P10,000.

Since the P10,000 payment is to be made on December 31, 2012, it is discounted for one year. The
present value of 1 at 8% for one period is .9259. Thus, the fair value of the interest rate swap payable
on December 31, 2011 is P10,000 times .9259 or P9,259.

## Problem 27-6 (IAA)

Tagaytay Company is a golf course developer that constructs approximately 5 courses each year. On
January 1, 2011, Tagaytay Company has agreed to buy 5,000 trees on January 31, 2012 to be planted
in the courses it intends to build. In recent years, the price of trees has fluctuated wildly. On January
1, 2011, Tagaytay entered into a forward contract with a reputable bank. The price is set at P500
per tree.

The derivative forward contract provides that if the market price on January 31, 2012 is more than
P500, the difference is paid by the bank of Tagaytay. On the other hand, if the market price is less than
P500, Tagaytay will pay the difference to the bank. This derivative forward contract was designated as
cash flow hedge. The market price on December 31, 2011 and January 31, 2012 is P800. The appro-
priate discount rate is 8% and the present value of 1 at 8% for one period is .926.

On December 31, 2011, what amount should be recognized by Tagaytay Company as derivative asset
or liability?

a. 1,500,000 asset
b. 1,389,000 liability
c. 1,500,000 liability
d. 1,389,000 asset

The entry on December 31, 2011 is:

## Forward contract receivable 1,500,000

Unrealized gain -- forward contract 1,500,000
(5,000 x P300)

## The forward contract receivable is the derivative asset.

The amount is not discounted anymore because it is to be received on January 31, 2012.

## Tree inventory (5,000 x P800) 4,000,000

Cash 4,000,000
Cash 1,500,000
Forward contract receivable 1,500,000
Unrealized gain -- forward contract 1,500,000
Gain on forward contract 1,500,000

## Problem 27-7 (IAA)

Carmona Grill operates a chain of seafood restaurants. On January 1, 2011, Carmona Grill determined
that it will need to purchase 100,000 kilos of tuna fish on February 1, 2012. Because of the volatile
fluctuation in the price of tuna fish, on January 1, 2011, Carmona negotiated a forward contract with
a reputable financial institution for Carmona Grill to purchase 100,000 kilos of tuna fish on February
1, 2012 at a price of P8,000,000 or P80 per kilo, This forward contract was designated as cash flow
hedge.

On December 31, 2011 and February 1, 2012, the market price of tuna fish per kilo is P75. The appro-
priate discount rate is 6% and the present value of 1 at 6% for one period is .943.

What amount should be recognized by Carmona Grill as derivative asset or liability on December 31,
2011?

a. 471,500 asset
b. 500,000 asset
c. 471,500 liability
d. 500, 000 liability

The entry on December 31, 2011 to recognize the reduction in the market price is:
Unrealized loss -- forward contract 500,000
Forward contract payable (100,000 x P5) 500,000

## The forward contract payable is the derivative liability.

Because of the reduction in the market price on Febraury 1, 2012, Carmona Company shall make a
forward contract payment to the financial institution.

## The entries on February 1, 2012 are:

Purchases 7,500,000
Cash (100,000 x P75) 7,500,000

## Forward contract payable 500,000

Cash 500,000
Loss on forward contract 500,000
Unrealized loss -- forward contract 500,000

## Problem 27- 8 (IAA)

Chavacano Company a seafood restaurant. On October 1, 2011, Chavacano determined that it will
need to purchase 50,000 kilos of deluxe fish on March 1, 2012. Because of the volatile fluctuation
in the price of deluxe fish, on October 1, 2011, Chavacano negotiated a forward contract with a re-
putable for Chavacano to purchase 50,000 kilos of deluxe fish on March 1, 2012 at a price of P50
per kilo or P2,500,000. This forward contract was designated as a cash flow hedge. The derivative
forward contract provides that if the market price of deluxe fish on March 1, 2012 is more than P50,
the difference is paid by the bank to Chavacano. On the other hand, if the market price on March 1,
2012 is less than P50, Chavacano will pay the difference to the bank. On December 31, 2011, the
market price per kilo is P60 and on March 1, 2012, the market price is P58. The appropriate discount
rate is 8%. The present value of 1 is 8% for one period is .93.

1. What is the fair value of the derivative asset or liability on December 31, 2011?

a. 500,000 asset
b. 500,000 liability
c. 465,000 asset
d. 465,000 liability

2. What is the fair value of the derivative asset or liability on March 1, 2012?

a. 400,000 asset
b. 400,000 liability
c. 372,000 asset
d. 372,000 liability

Solution 27-8
Excess of market price over underlying price 12/31/2011
(60 - 50) 10
Forward contract receivable -- 12/31/2011 (50,000 x 10) 500,000

## Excess of market price over underlying price 3/1/2012

(58 - 50) 8
Forward contract receivable -- 3/1/2012 (50,000 x 8) 400,000

## Problem 27- 9 (IAA)

Seaside Company operates a five-star hotel. The entity makes very detailed long-term planning. On
October 1, 2011, Seaside Company determined that it would need to purchase 8,000 kilos of Austra-
lian lobster on January 1, 2013.

Because of the fluctuation in the price of the Australian lobster, on October 1, 2011, the entity nego-
tiated a forward contract with a bank for Seaside to purchase 8,000 kilos of Australian lobster on
January 1, 2013 at a price of P9,600,000. The price of Australian lobster is P1,200 per kilo on October
1, 2011. This forward contract was designated as cash flow hedge. The entity is predicting a drop in
worldwide lobster prices between October 1, 2011 and January 1, 2013.

On December 31, 2011, the price of a kilo of Australian lobster is P1,500. On December 31, 2012,
and January 1, 2013, the price of a kilo of Australian lobster P1,000. The appropriate discount rate
throughout this period is 10%. The present value of 1 at 10% for one period is .91.

a. 12,000,000
b. 9,600,000
c. 7,200,000
d. 4,800,000

## 2. What is the derivative asset or liability on December 31, 2011?

a. 2,400,000 asset
b. 2,400,000 liability
c. 2,184,000 asset
d. 2,184,000 liability

## 3. What is the derivative asset or liability on December 31, 2012?

a. 1,600,000 asset
b. 1,600,000 liability
c. 800,000 asset
d. 800,000 liability

Solution 27-9

The notional figure is 8,000 kilos and the notional value is 8,000 kilos times the underlying fixed
price of P1,200 per kilo or P9,600,000.

## Market price -- December 31, 2011 1,500

Underlying fixed price 1,200

## Present value of a derivative asset (2,400,000 x .91) 2,184,000

The present value of P2,184,000 is recognized as forward contract receivable on December 31, 2011
because the amount is collectible on January 1, 2013, one year from December 31, 2011.

The entry to recognized the derivative asset on December 31, 2011 is:

## Forward contract receivable 2,184,000

Unrealized gain -- forward contract 2,184,000

## Market price -- December 31, 2012 1,000

Underlying fixed price 1,200

## Forward contract payable -- 12/31/2012 (8,000 x 200 ) 1,600,000

The entry to recognized the derivative liability on December 31, 2012 are:

## Unrealized loss -- forward contract 1,600,000

Forward contract payable 1,600,000

## Problem 27-1- (IAA)

Indang Company requires 40,000 kilos of soya beans each month in its operations. To eliminate the
price risk associated with the purchase of soya beans, on December 1, 2011, Indang entered into a
futures contract as a cash flow hedge to buy 40,000 kilos of soya beans at P150 per kilo on March
1, 2012.

The market price on December 31, 2011 and March 1, 2012 is P160 per kilo. The appropriate discount
rate is 9% and the present value of 1 at 9% for one period is .917.
What amount should be recognized by Indang Company on December 31, 2011 as derivative asset
or liability?

a. 400,000 asset
b. 400,000 liability
c. 366,800 asset
d. 366,800 liability

## Future contract receivable (40,000 x P10) 400,000

Unrealized gain -- futures contract 400,000

## Market price -- December 31, 2011 160

Underlying fixed price 150

Derivative asset 10

## The entries on March 1, 2012 are:

Purchases 6,400,000
Cash (40,000 x P160) 6,400,000

Cash 400,000
Futures contract receivable 400,000

## Unrealized gain -- futures contract 400,000

Gain on futures contract 400,000

## Problem 27-11 (IAA)

Naga Company produces bottled grape juice. Grape juice concentrate is typically bought and sold by
the pound. Naga uses 50,000 pounds of grape juice concentrate each month.

On November 1, 2011, Naga entered into a grape juice concentrate futures contract as cash flow
hedge to buy 50,000 pounds of concentrate on February 1, 2012 at a price of P50 per pound.

The market price on December 31, 2011 and February 1, 2012 of the grape juice concentrate is P38
per pound. The appropriate discount rate is 11%. The periodic system is used.
What amount should be recognized by Naga Company aon Decemer 31, 2011 as derivative asset or
liability?

a. 540,540 asset
b. 540,540 liability
c. 600,000 liability
d. 600,000 asset

## Unrealized loss -- futures contract 600,000

Futures contract payable (50,000 x P12) 600,000

## Market price -- December 31, 2011 38

Underlying fixed price 50

Derivative liability 12

## Entries on February 1, 2012 are:

Purchases 1,900,000
Cash (50,000 x P38) 1,900,000

Cash 600,000

## Loss on futures contract 600,000

Unrealized loss -- futures contract 600,000

## Problem 27-12 (IAA)

Taal Company requires 25,000 pounds of copper each month in its operations. To eliminate the price
risk associated with copper purchases, on December 1, 2011, Taal Company entered into a futures
contract as a cash flow hedge to buy 25,000 pounds of copper on June 1, 2012. The futures price
is P50 per pound.

The futures contract is managed through an exchange, so Taal does not know the other party on the
other side of the contract. As with most derivative contracts, this futures contract is settled by an ex-
change of cash on June 1, 2012 based on the price of copper on that date.

The market price per pound is P45 on December 31, 2011 and P42 on June 1, 2012.

## What is the derivative asset or liability on December 31, 2011?

a. 125,000 asset
b. 125,000 liability
c. 200,000 asset
d. 200,000 liability

## Market price -- December 31, 2011 45

Underlying fixed price 50

Derivative liability 5

## Market price -- June 1, 2012 42

Underlying fixed price 50

Derivative liability 8

## Futures contract payable -- June 1, 2012 (25,000 x 8) 200,000

Futures contract payable -- December 31, 2011 125,000
Increase in derivative liability on June 1, 2012 75,000

## Problem 27-13 (IAA)

Legaspi Company produces colorful 100% cotton T-shirts that are very popular among youth. The
entity uses 150,000 kilos of cotton each month in its production process. In accordance with the enti-
ty's long-term planning, the entity normally procures one month supply of cotton to be used in its
production process. On December 31, 2011, Legaspi Company purchased a call option as cash flow
hedge to buy 150,000 kilos of cotton on July 1, 2012. The call option price is P30 per kilo. The
entity paid P50,000 for the call option. The market price of cotton on July 1, 2012 is P35 per kilo.
What amount should be recognized by Legaspi Company as gain on call option in 2012?

a. 750,000
b. 700,000
c. 375,000
d. 350,000

## Fair value of call option on 7/1/2012 (150,000 x P5) 750,000

Call option payment ( 50,000)

## Gain on call option 700,000

The entry on December 31, 2011 for the payment of the call option is:

Cash 50,000

## Call option 700,000

Unrealized gain -- call option 700,000

Cash 750,000
Call option 750,000

Purchases 5,250,000
Cash (150,000 x P35) 5,250,000

## Unrealized gain -- call option 700,000

Gain on call option 700,000

## Problem 27-14 (IAA)

Bicol Company uses approximately 200,000 units of raw material in its manufacturing operations.
On December 31, 2011, Bicol Company purchased a call option to buy 200,000 units of the raw
material on July 1, 2012 at a price of P25 per unit. The entity paid P20,000 for the call option. Bicol
designated the call option as a cash flow hedge against price fluctuation for its July purchase. The
market price of the raw material on July 1, 2012 is P22 per unit.

What amount should be recognized by Bicol Company as loss on call option in 2012?

a. 600,000
b. 550,000
c. 650,000
d. 20,000

The loss on call option is equal only to the payment of P20,000. Since the market price has decreased
on July 1, 2012, the call option is not exercised but simply ignored. Remember that a call option is
a right and not an obligation.

The entry to record the payment of the option on December 31, 2011 is:

Cash 20,000

## Raw materials purchases 4,400,000

Cash (200,000 x P22) 4,400,000

## Loss on call option 20,000

Call option 20,000
eive P60,000
e on Decem-
ariable rate
th the loan,
with another
P5,000,000

P5,000,000

January 1 of

variable debt.
wap payable

e is less than
designated as
l determined

ontract with

. The appro-

ecember 31,
ate discount
o on October
iate discount
s decreased