Zermatt Company – Option Fair Value Hedge of a Foreign Currency Firm Purchase Commitment — The ordered parts from supplier November price 100 000 francs when spot

The Zermatt Company ordered parts from a foreign supplier on November 20 at a price of 100,000 francs when the spot rate was $0.80 per peso. Delivery and payment were scheduled for December 20. On November 20, Zermatt acquired a call option on 100,000 francs at a strike price of $0.80, paying a premium of $0,008 per franc. The option is designated as a fair value hedge of a foreign currency firm commitment. The fair value of the firm commitment is measured through reference to changes in the spot rate. The parts are delivered and paid for according to schedule. Zermatt does not close its books until December 31.

Required:

a. Assuming a spot rate of $0.83 per franc on December 20, prepare all journal entries to account for the option and firm commitment.

b. Assuming a spot rate of $0.78 per franc on December 20, prepare all journal entries to account for the option and firm commitment.

SOLUTION

Zermatt Company – Option Fair Value Hedge of a Foreign Currency Firm Purchase Commitment

Firm Commitment Option Foreign Currency Option

Spot Change in Premium Change in

Date Rate Fair Value Fair Value for 12/20 Fair Value Fair Value

11/20 $.80 - - $.008 $800 -

a) 12/20 $.83 $(3,000)1 – $3,000 $.030 $3,000 + $2,200

b) 12/20 $.78 $2,0002 + $2,000 $.000 $0 – $800

1 $80,000 – $83,000 = $(3,000).

2 $80,000 – $78,000 = $2,000.

a. The option strike price ($.80) is less than the spot rate ($.83) on December 20, the date the parts are to be paid for. Therefore, Zermatt will exercise its option. The journal entries are as follows:

11/20 Foreign Currency Option $800

Cash [$.80 x 100,000 francs] $400

There is no entry to record the sales agreement as it is an executory contract.

12/20 Loss on Firm Commitment $3,000

Firm Commitment $3,000

Foreign Currency Option $2,200

Gain on Foreign Currency Option $2,200