OPTION CONTRACTS

An option is a financial derivative contract that provides the holder the right to buy or sell an underlying in the
future, for a price set today. The price of the option is separate from the price of the underlying. The following
terms are usually associated on option contracts.
1) Premium- the option price. This is the sum of money that the option buyer pays the option seller to obtain
the "right" being sold in the option. This money is paid when the option contract is initiated.

2) Time value of the option-

this is the difference between the option's market price and its intrinsic value.
Changes in the time value of the option are taken to current earnings.

3) Intrinsic value of the option- this is the difference between the current market price and the option price
of the hedged item, This is also the value of the option if it is exercised today.

4) Strike price-
the price at which the holder has the option to buy or sell the item.

5) Option to buy "in the money"-- this exists when the market price is more than the strike price.
(opposite if Option to sell)
6) Option to buy "out of the money"- this exists when the market price is less than the strike price.
(opposite if option to sell)

7) Underlying- the asset, financial instrument, or any other basis (ex., interest rates) to which the option is linked,
and from where its value is derived. The underlying can be a stock, bonds, interest rates,
foreign currency or commodity.

TWO BASIC TYPES OF OPTIONS

1) Call option-
on aption granting the right to buy an underlying. Options of this type may simply be called "CALLS".

2) Put option-
an option granting the right to sell an underlying. Options of this type may simple be called "PUT"

ILLUSTRATION FOR A CALL OPTION

Power Corporation shares are currenty traded at P65. An option to buy 1,000 shares at P68 per share three months
from now is worth P2 per share. If the option is bought, the call buyer's positions are:
a) The option buyer will pay the option seller the premium of P2,000 (P2 x 1,000 sh)
b) If, at the end of three months, the stocks trade at P75:
1) the option buyer will exercise,and thus pay the option seller the amount of P68,000 (1,000 sh x P68)
2) The buyer may either keep the stocks or sell them:
a) if he holds the stocks, he'll record the investment in his books at P75,000 (market value)
b) if he sells the stocks, he'll receive P75,000 from the sale.

c) if,at the end of 3 months, the stocks traded at P66:

a)The option buyer will not exercise the option. His loss with be the premium payment of P2,000 only.
b) If he exercises the option, he'll pay the seller P68,000 and own 1,000 shares that he can sell for only
P66,000. He will lose P2,000 (P68,000-66,000) plus the P2,000 option premium for a total loss of P4,000.

d) If, at the end of 3 months, the stocks traded at P68 (the strike price), the option buyer will not realize any
gain from the exercise of the option.

ILLUSTRATION FOR A PUT OPTION

SM, INC.shares currently trades at P15 per share. An option to sell 1,000 shares for P17 three months from now is
worth P2 per share. If the option is bought, the option buyer's positions are:
 1) The option buyer will pay the option seller the premium of P2,000
2) if, at the end of 3 months, the stock is traded at P11:
a) The option buyer will exercise; buy 1,000 shares from the market for P11,000, give the stocks to the
option seller and receive P17,000.
b) The option buyer netted P4,000 (P6,000 gain from the sale of the stocks minus the optio premium of
P2,000)

3) If, at the end of 3 months, the stocks traded at P20:

The option buyer will not exercise the option, and he loses only the P2,000 premium.
If he exercises the option, he'll buy the stocks for P20K and sell them to the option seller for only
P17,000, thus losing P3,000 on the sale, plus the P2,000 loss on the premium.

4) If at the end of 3 months, the stocks traded at P17, the option buyer will definitely not exercise the option
(no gain from the effort).

FOREIGN CURRENCY OPTION-

A foreign currency option gives the holder the option the right but not the obligation to trade foreign currency in the
future. A PUT option is for the sale of foreign currency by the holder of the option. A Call option is for the purchase
of foreign currency by the holder of the option.

ILLUSTRATION: Assume that a Pilipino Company sold inventory to a foreign customer with collection due in FC and that
the company acquired a PUT option to sell FC. Additional information are as follows:
a) On Nov.1,2021, the amount of inventory sold is 100,000 FC (cost:P320,000).Payment is due on Feb.1,2022.
b) On the same day, the company purcbased an out-of the-money put option to sell 100,000 FC on Feb.1,2022 at a
strike price of P5.1 per 1 FC. An option premium of P4,000 was paid.
c) Spot rates, option values, and changes in value over time are as follows:
11/01/2021 12/31/21 02/01/2022
Strike price (1 FC) P5.10 P5.10 P5.10
Spot rate (1 FC) P5.15 P4.98 P4.95
Fair value of option P4,000 P13,000 P15,000
Intrinsic value of option P0 P12,000 P15,000
Time Value P4,000 P1,000 P0

Note: Bec.the strike price is less than the spot rate on Nov.1, the option has no intrinsic value. The entire fair value is
attributable to time value only.

A) THE OPTION WAS DESIGNATED AS A FAIR VALUE HEDGE. The journal entries to record the foregoing transactions are:
Relating to the sale of the inventory Relating to the Put option
Nov.1,2021:
Accounts Receivable-FC 515,000 Investment in Put option 4,000
Sales 515,000 Cash 4,000

Cost of Sales 320,000

Inventory 320,000

Dec.31,2021
Forex Loss 17,000 Investment in Put option 9,000
Accounts Receivable-FC 17,000 Gain on put option 9,000
Feb 1,2022
Cash-FC 495,000 Investment in Put option 2,000
Forex Loss 3,000 Gain on put option 2,000
Accounts Receivable-FC 498,000
Cash 510,000
Cash (FC) 495,000
Investment in Put option 15,000

Note: The gain or loss on the FV of the option is immediately recognized in net income; the change in the time value of the
option is not recognized separately.

B) THE OPTION WAS DESIGNATED AS A CASH FLOW HEDGE. The journal entries for the changes in the fair value of
the option will be as follows:
Nov.1,2021Investment in Put option 4,000
Cash 4,000

Dec.31,2021
Investment in Put option 9,000
Loss on Put option (decrease in Time value) 3,000
OCI (increase in intrinsic value) 2,000

Feb.1,2022Investment in Put option 2,000

Loss on Put option (decrease in Time value) 1,000
OCI (increase in intrinsic value) 3,000

Cash 510,000
Cash-FC 495,000
Investment in Put option 15,000

OCI 15,000
Gain on Put option (or cost of sales) 15,000

Note: The change in time value is immediately recognized in profit or loss, while the change in intrinsic value
is deferred as other comprehensive income.

INTEREST RATE SWAP TO HEDGE VARIABLE DEBT RATE (A CASH FLOW HEDGE)
On June 30, 2020, Family Corp. borrows P5M of thee-year variable rate debt with interest payments equal
to the six-month inter-bank interest rate for the prior six months. The company then enters into a three-year
interest rate swap with Metro Bank to convert the debt's variable rate to a fixed rate. The swap agreement
specifies that Family Corp. will pay interest at a fixed rate of 7.5% and receive interest at a variable rate equal
to the six-month inter-bank rate based on the notional amount of P5M. Both the debt and the swap require
interest to be paid semi-annually on June 30 and December 31.

The six-month inter-bank interest rates and the market value for the first hear of the swap agreement is as
follows: Six-Month Swap agreement fair valiue
Date Inter-Bank rate Asset (Liability)
June 30,2020 6.00% P0
Dec.31, 2020 7.00% P165,000
June 30,2021 5.50% (P70,000)

Family's payments on the variable-rate and the net payments to Metro Bank on the interest-swap agreement
for the initial two semi-annual periods are presented below:
Interest payments
12/31/20 06/30/2021
Variable rate interest payment P150,000 (a) P175,000 (b)
Interest rate swap net payments 37,500 ( c ) 12,500
P187,500 P187,500

( a) P5,000,000 x .06 x 6/12

( b ) P5,000,000 x .07 x 6/12
( c ) net payment required to Metro Bank for the difference between variable and fixed rate
(d) P187,500 = P5,000,000 x .075 fixed rate x 6/12

Prepare journal entries for 2020 and 2021.

e of the