Question

A Company produces colorful 100% cotton shirts and the entity needs 50,000 kilos of raw materials in the production process. On December 1, 2018, the entity purchased a call option as a cash flow hedge to buy 50,000 kilos on July 1, 2019. The option strike price is P100 per kilo. The entity paid P50,000 for the call option. This derivative option contract means that if the market price is higher than P100, the entity can exercise the option and buy the asset at the strike option price of P100. If the market price is lower than P100, the entity can throw away the option and buy the asset at the cheaper price. The market price per kilo is P110 on December 31, 2018 and P115 on July 1, 21019.

1. What is the derivative asset on December 31, 2018?
2 what is the cash settlement from the speculator on July 1, 2015.
3 Assume the market price is P110 on December 31, 2018 and P90 on July 1, 2019. What amount should be recognized as loss on call option in 2019?
4. Assume the market price is P110 on December 31, 2018 and P90 on July 1, 2019. What is the derivative liability on July 1, 2019?

Answer 1

Given data,

Call option entered for 50,000 kilos of raw materials

Option Strike Price = P100 per kilo

Date of entering into option contract = 01.12.2018

Date of Settlement = 01.07.2019

Option Premium paid = P50,000

Case 1:

By problem, Market price of raw material as on 31.12.2018 = P110 per kilo

We know, as on the reporting date the Derivative Asset in option contract

= [(Market price of the option as on the reporting date - Strike price of the option) * Quantity]

Therefore, Derivative Asset on 31.12.2018 = [(P110 - P100) * 50,000kilos ] = P500,000

Hence, as on 31.12.2018 company A will recognise derivative asset of P500,000

Case 2:

By problem, Market price of raw material as on 01.07.2019 = P115 per kilo

We know, as on the settlement date Cash Settlement amount

=[(Market price of the option as on the settlement date - Strike price of the option) * Quantity]

Therefore, amount to be settled in cash as on 01.07.2019 = [(P115 - P110) * 50,000kilos] = P750,000

Hence, company A will receive P750,000 as on 01.07.2019 as Cash settlement

Case 3:

By problem, Market price of raw material as on 31.12.2018 = P110 per kilo

Market price of raw material as on 01.07.2019 = P90 per kilo

As mentioned in the question, as on the settlemnt date if the market price is lower than P100, the entity can throw away the option and buy the asset at the cheaper price. Hence, if the market price of raw material as on 01.07.2019 is P90, company A will not exercise the option contract @ P100 per kilo, rather they will purchase the raw material from open market at spot rate i.e., P90 per kilo.

However, the amount paid as an Option Premium as on the date of contract is non-refundable. Hence, that amount would be loss for the company.

Therefore, loss on call option = P50,000

Case 4:

By problem, Market price of raw material as on 31.12.2018 = P110 per kilo

Market price of raw material as on 01.07.2019 = P90 per kilo

As mentioned in Case 3, if the spot rate as on the settlement date is lower than the strike price of the option company A is not liable to settle the contract. Therefore, there would be no standing liability to the company as on 01.07.2019

Hence, Derivative Liability as on 01.07.2019 = Nil