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27DERIVATIVESProblem 27-1 (IAA)On January 1, 2010, Pasay Company entered into a two-year P 3,000,000 variable interest rate loan at the prevailing rate of 12%. In 2011, the interest rate is equal to the prevailing interest rate at the beginning of the year.The principal loan is payable on December 3...

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27 DERIVATIVES Problem 27-1 (IAA) On January 1, 2010, Pasay Company entered into a two-year P 3,000,000 variable interest rate loan at the prevailing rate of 12%. In 2011, the interest rate is equal to the prevailing interest rate at the beginning of the year. The principal loan is payable on December 31, 2011 and the interest is payable on December 31 of each year. On January 1, 2010, 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, 2011 is 4% and the present value of 1 at 14% for one period is .877. How much should be reported as “interest rate swap receivable” on December 31, 2010? a. b. c. d.

60,000 52,620 30,000 0

Solution 27-1 Answer b Since the interest on January 1, 2011 is 14% which is 2% higher than the fixed rate of 12%, it means that Pasay Company shall receive P 60,000 from the bank on December 31, 2011. This receivable is recognized as a derivative asset on December 31, 2010 at present value of P 52,620 as follows: Interest rate swap receivable Unrealized gain-interest swap (60,000 x .877)

52,620 52,620

On December 31, 2011, when the amount of P 60,000 is received from the bank by Pasay Company, the entry is: Cash

60,000 Interest swap receivable Unrealized gain-interest rate swap

52,620 7,380

The unrealized gain on the interest rate swap is then offset against the interest expense for 2011 as follows: Unrealized gain-interest rate swap Interest expense

60,000 60,000

Actually, the entries to record the payment of annual interest for 2011 and the principal payment are: Interest expense (3,000,000 x 14%) Cash

420,000

Loan payable Cash

3,000,000

420,000 3,000,000

Accordingly, the net interest expense is P 420,000 minus P 60,000 or P360,000 which is equal to the fixed rate of 12% times P3,000,000.

Problem 27-2 (IAA) Imus Company received a two-year variable interest rate loan of P 5,000,000 on January 1, 2010. The interest on the loan is payable on December 31 of each year and the principal is to be repaid on December 31, 2011. On January 1, 2010, Imus Company entered into a “receive variable, pay fixed” interest rate swap agreement with a speculator bank designated as a cash flow hedge. The interest rate for 2010 is the prevailing interest rate of 10% and the rate in 2011 is equal to the prevailing rate on January 1, 2011. The market rate of interest on January 1, 2011 is 7% and the present value of 1 at 7% for one period is .935. How much should be reported by Imus Company on December 31, 2010 as “interest rate swap payable”? a. b. c. d.

150,000 140,250 100,000 0

Solution 27-2 Answer b Since the interest rate on January 1, 2011 is 7% which is 35 lower than the fixed rate of 10%, it means that Imus Company shall pay the bank P 150,000 on December 31, 2011 or P 5,000,000 times 3%.

The interest rate swap payable is recognized as a derivative liability on December 31, 2010 as follows: Unrealized loss-interest rate swap Interest rate swap payable (150,000 x .935)

140,250 140,250

On December 31, 2011, the pertinent entries are: 1. Payment of the loan: Loan payable Cash

5,000,000 5,000,000

2. Payment of annual interest: Interest expense (5,000,000 x 7%) Cash

350,000 350,000

3. Interest swap payment to the bank: Interest rate swap payable Unrealized loss- interest rate swap Cash

140,250 9,750 150,000

4. Adjustment of the unrealized loss: Interest expense Unrealized loss- interest rate swap

150,000 150,000

Observe that the net interest expense for 2011 is equal to P 500,000 which is the fixed rate of 10% times P 5,000,000.

Problem 27-3 (IAA) On January 1, 2010, Taal Company received a 5-year variable interest rate loan of P6,000,000 with the interest payment at the end of each year and the principal to be paid on December 31, 2014. The interest rate for 2010is 8% and the rate in each succeeding year is equal to market interest rate on January 1 of each. On January 1, 2010, Taal Company entered into an interest rate swap agreement with a financial institution 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. The interest rate swap agreement is designated as a cash flow hedge. On January 1, 2011, 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, 2010, how much should be reported by Taal Company as “interest rate swap receivable”? a. b. c. d.

300,000 240,000 194,400 120,000

Solution 27-3 Answer c The interest rate on January 1, 2011 is 9% which is 1% higher than the fixed rate of 8%. This means that Taal Company shall receive an annual interest swap payment from the financial institution of P 6,000,000 times 1% or P 60,000. Since the term of the loan is 5 years and one year already expired, Taal Company shall receive P 60,000 at the end of 2011 and can expect to receive P 60,000 at the end of 2012, 2013 and 2014. Thus, the present value of the four annual payments of 60,000 is recognized as interest rate swap receivable on December 31, 2010 or P 60,000 times 3.24 equals P 194,400.

Problem 27-4 (IAA) On January 1, 2010, Trece Company borrowed P 5,000,000 from a bank at a variable rate of interest for 4 years. Interest will be paid annually to the bank on December 31 and the principal is due on December 31, 2013. Under the agreement, the market rate of interest every January 1 resets the variable for that period and the amount of interest to be paid on December 31. In conjunction with the loan, Trece Company entered into a “receivable 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, 2010 January 1, 2011 January 1, 2012 January 1, 2013

10% 14% 12% 11%

The present value of an ordinary annuity of 1 is as follows: At 14% for three periods At 12% for two periods At 11% for one period

2.32 1.69 0.90

1. What is the “notional” of the interest rate swap agreement? 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, 2010? a. b. c. d.

464,000 asset 464,000 liability 600,000 asset 600,000 liability

3. What is the derivative asset or liability on December 31, 2011? a. b. c. d.

200,000 asset 200,000 liability 169,000 asset 169,000 liability

4. What is the derivative asset or liability on December 31, 2010? a. b. c. d.

45,000 asset 45,000 liability 50,000 asset 50,000 liability

Solution 27-4 Question 1 Answer a The “notional” of the interest rate swap agreement is equal to the principal amount of the loan or P5, 000,000. Question 2 Answer a

The interest rate on January 1, 2011 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 P 5,000,000 or P200, 000 annually for 2011, 2012 and 2013. The present value of the three annual payments is P 200,000 times 2.32 or P464, 000. This amount is recognized on December 31, 2010 as interest rate swap receivable which is a derivative asset. Question 3 Answer c The interest rate on January 1, 2012 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 P 5,000,000 or P 100,000 annually for 2012 and 2013. The present value of the two annual payments is P 100,000 times 1.69 or P 169,000. This amount must be the interest rate swap receivable on December 31, 2011. Question 4 Answer a The interest rate on January 1, 2013 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 P 50,000 on December 31, 2013. The present value of P 50,000 payments is P 50,000 times .90 or P 45,000. This amount must be the interest rate swap receivable on December 31, 2012.

Problem 27-5 (IAA) On January 1, 2010, Camry Company received a two-year P 500,000 loan. The loan calls for interest payments to be made at the end of each year based on the prevailing market rate at January 1 of each year. The interest rate at January 1, 2010 was 10 percent. Fortuner Company also has a two-year P 500,000 loan but Fortuner’s loan carries a fixed interest rate of 10 percent. 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 2011 and Camry likewise agrees to make Fortuner’s interest payment in 2011. The two entities agree to make settlement payments, for the difference only, on December 31, 2011. 1. If the interest rate on January 1, 2011 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, 2010? a. 500,000 b. 10,000 c. 9,259 d. 9,091 Solution 27-5 Question 1 Answer a Since the interest rate of 8% on January 1, 2011 is lower than the underlying 10% rate, Camry is required to pay Fortuner the difference of 2% times P 500,000 or P10, 000. Question 2 Answer c Since the P 10,000 payment is to be made on December 31, 2011, it is discontinued for one year. The present value of 1 at8% for one period is .9259. Thus, the fair value of the interest rate swap payable on December 31, 2010 is P 10,000 times .9529 or P 9,529.

Problem 27-6 (IAA) Tagaytay Company is a golf course developer that constructs approximately 5 courses each year. On January 1, 2010, Tagaytay Company has agreed to buy 5,000 trees on January 31, 2011 to be planted in the course intends to build. In recent years, the price of trees has fluctuated wildly. On January 1, 2010, Tagaytay Company 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, 2011 is more than P500, the difference is paid by the bank to 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 a cash flow hedge. The market price on December 31, 2010 and January 31, 2011 is P800. The appropriate discount rate is 8% and the present value of 1 at 8% for one period is .926. On December 31, 2010, what amount should be recognized by Tagaytay Company as derivative asset or liability? a. b. c. d.

1,500,000 asset 1,389,000 liability 1,500,000 liability 1,389,000 asset

Solution 27-6 Answer a The entry on December 31, 2010 is: Forward contract receivable Unrealized gain-forward contract (5,000 x P300)

1,500,000 1,500,000

The forward contract receivable is the derivative asset. The amount is not discontinued anymore because it is to be received on January 31, 2011. The entries on January 31, 2011 are: Tree inventory (5,000 x P800) Cash

4,000,000

Cash

1,500,000

4,000,000

Forward contract receivable Unrealized gain-forward contract Gain on forward contract

1,500,000 1,500,000 1,500,000

Problem 27-7 (IAA) Carmona Grill operates a chain of seafood restaurants. On January 1, 2010, Carmona Grill determined that it will need to purchase 100,000 kilos of tuna fish on February 1,011. Because of the volatile fluctuation in the price of tuna fish, on January 1, 2010, Carmona negotiated a forward contract with a reputable financial institution for Carmona Grill to purchase 100,000 kilos of tuna fish on February 1, 2011 at a price of P 8,000,000 or P80 per kilo. This forward contract was designated as a cash flow hedge. On December 31, 2010 and February 1, 2011, the market price of tuna fish per kilo is P75. The appropriate 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 o December 31, 2010? a. b. c. d.

471,500 asset 500,000 asset 471,500 liability 500,000 liability

Solution 27-7 Answer d The entry on December 31, 2010 to recognize the reduction in the market price is: Unrealized loss – forward contract Forward contract payable

500,000 500,000

The forward contract payable is the derivative liability. Because of the reduction in the market price on February 1, 2011, Carmona company shall make a forward contract payment to the financial institution. The entries on February 1, 2011 are: Purchases Cash (100,000 x P75)

7,500,000 7,500,000

Forward contract payable Cash

500,000

Loss on forward contract Unrealized loss – forward contract

500,000

500,000 500,000

Problem 27-8 (IAA) Chavacano Company operates a seafood restaurant. On October 1, 2010, Chavacano determined that it will need to purchase 50,000 kilos of Deluxe fish on March 1, 2011. Because of the volatile fluctuation in the price of deluxe fish, on October 1, 2010, Chavacano negotiated a forward contract with a reputable bank for Chavacano to purchase 50,000 kilos of deluxe fish on March 1, 2011 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, 2011 is more than P50, the difference is paid by the bank to Chavacano. On the other hand, if the market price on March 1, 2011 is less than P50, Chavacano will pay the difference to the ban. On December 31, 2010, the market price per kilo is P60 ad on March 1, 2011, the market price is P58. The appropriate discount rate is 8%. The present value of 1 at 85 for one period is .93.

1. What is the fair value of the derivative asset or liability on December 3, 2010? a. b. c. d.

500,000 asset 500,000 liability 465,000 asset 465,000 liability

2. What is the fair value of the derivative asset or liability on March 1, 2011? a. b. c. d.

400,000 asset 400,000 liability 372,000 asset 372,000 liability

Solution 27-8 Question 1 Answer a Market price – December 31, 2010 Underlying price Derivative asset Forward contract receivable-12/31/2010 (50,000 x 10)

60 50 10 500,000

Question 2 Answer a Market price – March 1, 2011 Underlying price Derivative asset Forward contract receivable – 3/1/2011 (50,000 x 8)

58 50 8 400,000

The forward contract receivable recognized on December 31, 2010 is P 500,000. This amount is reduced by P 100,000 on March 1, 2011, because the amount actually collectible from bank is only P 400,000.

Problem 27-9 (IAA) Seaside Company operates a five-star hotel. The entity makes very detailed long-term planning. On October 1, 20101, Seaside Company determined that it would need to purchase 8,000 kilos of Australian lobster on January 1, 2012.

Because of the fluctuation in the price of Australian lobster, on October 1 ,2010, the entity negotiated a forward contract with a bank for Seaside to purchase 8,000 kilos of Australian lobster on January 1,2012 at a price of P9,6000,000. The price of Australian lobster was P1, 200 per kilo on October 1, 2010. This forward contract was designated as a cash flow hedge. The bank has a staff of financial analysts who specialize in forecasting lobster prices. These analysts are predicting a drop in worldwide lobster prices between October 1, 2010 and January 1, 2012. On December 31, 2010, the price of a kilo of Australian lobster is P1, 500. on December 31, 2011 and January 1, 2012, the price of a kilo of Australian lobster is P1, 000. The appropriate discount rate throughout this period is 10%. The present value of 1 at 10% for one period is .91. 1. What is the notional value of the forward contract? 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, 2010? a. b. c. d.

2,400,000 asset 2,400,000 liability 2,184,000 asset 2,184,000 liability

3. What is the derivative asset or liability on December 31, 2011? a. 1,600,000 asset b. 1,600,000 liability c. 800,000 asset d. 800,000 liability Solution 27-9 Question1 Answer b 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 P 9,600,000. Question 2 Answer c

Market price- December 31, 2010 Underlying fixed price Derivative asset

1,500 1,200 300

Forward contract receivable (8,000 x 300)

2,400,000

Present value of 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, 2010 because the amount is collectible on January 1, 2012, one year from December 31, 2010. Forward contract receivable Unrealized gain- forward contract

2,184,000 2,184,000

Question3 Answer b Market price – December 31, 2011 Underlying fixed price Derivative liability

1,000 1,200 200

Forward contract payable – 12/31/11 (8,000 x 200)

1,600,000

The pertinent entries in 2011 and 2012 are: 1.

To recognize the derivative liability on December 31, 2011: Unrealized loss-forward contract Forward contract payable

2.

2,184,000 2,184,000

To record the actual purchase on January 1, 2012 at P1,000 per kilo: Purchases (8,000 x 1,000) Cash

4.

1,600,000

To cancel the derivative basset that was recorded on December 31, 2010: Unrealized gain-forward contract Forward contract receivable

3.

1,600,000

8,000,000 8,000,000

To settle the derivative liability to the bank on January 1, 2012:

Forward contract payable Cash 5.

1,600,000 1,600,000

To close the unrealized loss on forward contract: Loss on forward contract Unrealized loss- forward contract

1,600,000 1,600,000

The loss on forward contract is an addition to the cost of goods in 2012. Accordingly, the loss on forward contract can be charged directly to the purchases account.

Problem 27-10 (IAA) Indang company requires 40,000 kilos of soya beans each month in its operation. To eliminate the price risk associated with the purchase of soya beans, On December 1, 2010, 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, 2011. The market price on December 31, 2010 and March 1, 2011 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, 2010 as derivative asset or liability? a. b. c. d.

400,000 asset 400,000 liability 366,800 asset 366,800 liability

Solution 27-10 Answer a The entry on December 31, 2010 is: Futures contract receivable (40,000 x P10) Unrealized gain- futures contract

400,000 400,000

The futures contract receivable is the derivative asset. The entries on March 1, 2011 are: Purchases Cash (40,000 x P160) Cash

6,400,000 6,400,000 400,000

Futures con...