solution1

This case is designed to give students an introduction to rudimentary financial instruments and how these different instruments can be used to hedge against the same event. Students are given a small excerpt on the principals of each instrument, but are encouraged to further their knowledge through additional research. (Some of this can be done through utilizing the link provided in the references section of the case). As students compose their responses to the case questions, students will gain a working understanding of the risks inherent in these instruments through composing a memo, performing the currency translations, and preparing the necessary journal entries to record the transactions. To bring all of their responses together, students will additionally, be required to describe how they feel the firm should report its hedging strategy and their possible ramifications for the company in its financial statements.

Completing questions one through seven will provide students with the necessary framework to begin to explore the FASB's Exposure Draft, "Accounting for Derivatives." In the concluding case questions, students are asked to identify how their journal entries in "broad terms" would have differed if the Exposure Draft had been in effect and comment on if the disclosure statement on off balance sheet risk in the company's financial statements would have changed.

This case would be most appropriate for use towards the end of an advanced accounting course, or early on in an accounting theory course. Students need to be framiliar with the derivative instruments used in the case and the accounting theory behind the journal entries and disclosure notes, in order to understand how the recent Exposure Draft would affect current standards.

Solution for Question #1. See question. Nicoll must first address its likelihood of actually being awarded the project. If the firm does not believe this is likely, it should not enter into any hedging strategy. To do this would be to assume unnecessary risk. However, if the firm does believe they will be awarded the contract, a hedging strategy should be designed. This strategy should be based upon how they feel exchange rates will fluctuate over the next few months. Finally, the firm should consider the inherent risks that are embedded into their alternative hedging strategies and chose one that is in line with their risk management policy.

To: Derek Nicoll, CEO Nicoll Corporation
From: Student's name, CPA and Financial Engineer
Memo: Hedging Strategies for Hamburg Client Bid

After reviewing my notes from our conversation regarding various strategies that would be available for your firm, I have prepared a table that outlines the general outcomes that could result from the use of a forward, futures, or option contract. The profit from the contract is not taken into consideration in these forecasted general outcomes.

Through review of the table you will note that if the bid is successful and the DM does increase, the firm will receive the DMs, which are now valued at more dollars per DM. However, the forward or futures hedge will reduce this gain, because the hedge will be a short position. If the option strategy is used, the put will expire worthless.

If the DM decreases, and the bid is successful, the forward or futures contract will reduce the loss caused by a decline in the DM's value. Please note, that the option will also achieve a similar result as it will too reduce the the loss on the DM.

If we are unfortunate, and the bid is not accepted and the DM increases, the forward or futures hedge will result in a significant speculative loss. This is the result of the firm not physically receiving the DM and having a short position in futures/forwards. If the option hedge is used, the put will expire worthless. Therefore, money will also be lost on the purchase of the put. Generally, this loss will be less than the loss that would have resulted in this scenario if the futures/forward strategy had been used, however, this is dependent on how rates actually fluctuate.

If the DM decreases, and the bid is not accepted, the forward/futures hedge should result in a significant speculative profit. This profit will occur because you will be short in the futures/forward market, you will have not received the DMs due to your failure to win the bid, and will be forced to purchase the DM to deliver at the current "low" spot rate. If the option hedge had been chosen, exercise of the put should also result in a significant profit.

I suggest that you review the table and discuss the possible ramifications of each strategy with members of your board. Also, review your risk management policy for derivative financial instruments to ensure that your selection is in accordance with the company's policies. Please contact me at my office if I can be of further service.

Additionally -- Derek, if you choose to go with the futures/forward strategy please call me so I can adequately outline the differences between the two instruments to you.

Outcome of Bid	No Hedge	Short Forward or Futures Hedge	Option Hedge (Buy Put)
Successful:
DM increases	Gain in DM.	Gain on DM reduced by hedge. Small profit or loss.	Put expires. Premium lost.
DM decreases	Loss on DM.	Loss on DM reduced by hedge. Small profit or loss.	Loss on DM reduced by exercise of put. Small profit or loss.
Unsuccessful:
DM increases	No effect.	Potentially large loss on DM.	Put expires. Premium lost.
DM decreases	No effect.	Potentially large gain on DM.	Potentially large gain on DM by exercise of put.

Solution #3. See question. Comparison of Outcomes from Forward/Futures Hedge and Option Hedge

THIS TABLE ILLUSTRATES HOW SENSITIVE NICOLL IS TO THE CASH FLOWS ASSOCIATED WITH THE BID.

Outcome	No Hedge	Forward or Futures Hedge*	Option Hedge sell put*
Bid successful, DM increases to .5520	Nicoll converts its DM to 40,000,000(.5520)= $22,080,000	Nicoll converts its DM to 40,000,000(.5405)= $21,620,000 using its forward or futures contract	Nicoll converts its DM to 40,000,000(.5520) = $22,080,000. Puts expire out-of-the money. Net amt realized is $22,080,000 - $292,000 (cost of puts) = $21,676,000
Bid successful, DM decreases to .5250	Nicoll converts its DM to 40,000,000(.5250)= $21,000,000	Nicoll converts its DM to 40,000,000(.5405)= $21,620,000 using its forward or futures contract	Nicoll exercises its puts to DMs 40,000,000(.5450) =$21,800,000. Net amt realized is 21,800,000 - $292,000(cost of puts) = $21,508,000
Bid unsuccessful, DM increases to .5520	No cash flow.	Nicoll must purchase 40,000,000 DM at $.5520 and deliver on its forward or futures contract for which it receives 40,000,000(.5405) = $21,620,000. Net loss is 40,000,000 x (.5405-.5520) = $460,000	Puts expire out of the money. Net loss is $292,000 (Cost of puts).
Bid unsuccessful, DM decreases to .5250	No cash flow.	Nicoll must purchase 40,000,000 DM at $.5250 and deliver on its forward or futures contract for which it receives 40,000,000 (.5405) = $21,620,000. Net Profit is 40,000,000 x (.5405 - .5250) = $620,000	Firms must purchase DMs costing 40,000,000DM x (.5250) = $21,000,000 and exercise puts, selling the DMs for 40,000,000(.5450)= $21,800,000. Net profit is -$292,000 (cost of puts) + 40,000,000( .5450 - .5250) = $508,000

* The firm needs to hedge 40,000,000 DM. Each forward contract is for 125,000 DM on the CME. So Nicoll must sell 320 contracts. The price of one futures contract is the forward rate of (.5405 - .5488)125,000 = $1037.5. The firm needs to hedge 40,000,000 DM/125,000 = 320 contracts. For a total of $332,000. For simplicity sake we will assume that Nicoll would have to pay a broker a $332,000 "discount" to obtain a similar forward contract.

* To compute the cost of the put options, we will assume the rate for a strike price of 5450 presented in the overview. Please note that the rates are for the CME. Contract amounts at the CME are twice that of the PHX exchange. At a strike price of 5450, Nicoll must pay $.0073 per mark to obtain the option. The effective cost of one contract is $912.50 times 320 contracts = $292,000.

[I would like to take a moment here to expound a little on the facts of the case. From the computation aspect of the transactions, the forward/futures hedge vs its put option counterpart, is not that great. However, this will not always be the case. If we were to change the currency to 25M English Pounds with final spot rates of 1.48 and 1.30, a future/forward rate of 1.424 and a total option premium of $625,000 (exercisable at 1.40), the loss on the forward/future on bid unsuccessful at 1.48 would be $1,400,000, whereas the put loss = $625,000. The loss at 1.30 forward/future on bid unsuccessful would be $3,100,000 whereas the put loss = $1,875,000.]

Solution to question #4A. See question. The least risky strategy for the company would be to not bid on the contract. However, this is unlikely because bidding on contracts is the nature of the company's business.

Yet, before deciding on a strategy, Nicoll should re-evaluate its likelihood of winning the bid. If this seems unlikely, no strategy should be selected. Their decision between the futures/forward hedge or option hedge should be based on the firm's risk management policies on derivative instruments and how Mr. Nicoll and the Board feel exchange rates are going to move over the next few months. The least risky strategy would probably be the purchase of the option - sell put hedge. When working through the "hypothetical numbers," this produces the smallest potential loss. Additionally, the potential loss can be better quantified for disclosure purposes in the company's year end financials (i.e. - the cost of the contract options is known). However, a student may choose a futures/forward hedge. Strategy selection is based on each individual's risk preferences.

The student's disclosure should identify that the company is involved in a off-balance sheet activity at year end, but does not need to disclose the amounts. It is recommended, but not required.

Solution to question 4B. See question.
12/31/x1 DISCLOSURE IN FINANCIALS -- Status of proposal not known

Foreign Exchange
The Company has significant foreign contracts with its clients. It is the company's policy to reduce substantially the effects of fluctuations in foreign currency exchange rates associated with these contracts by managing its currency exposure which includes foreign currency hedging activities. The Company enters into foreign exchange forward contracts to hedge the effect of foreign currency fluctuations on the financial statements.

The company enters into contracts to buy and sell foreign currencies in the future only to protect the U.S. dollar value of certain investments and future foreign currency transactions. The company does not engage in speculation. The gains and losses on these contracts are recognized and, for assets and liabilities, in the period in which the exchange rates change. The cash flows from forward contracts accounted for hedges of identifiable transactions are classified consistent with the cash flows from the transaction being hedge.

(1) Off-Balance Sheet Risk (Consulting FASB #105 & #119)
At December 31, x1, the Company has submitted to a potential client, a proposal not in the company's functional currency terms. The Company anticipates in early January, x2 to learn of the proposal's outcome. To minimize against the foreign exchange fluctuations associated with the bid, the company has entered into an anticipatory hedging strategy involving the purchase of [options or a forward contract]. The total gain or loss associated with the firm's strategy is not known at this time. The gain/loss portion associated with the [chosen] strategy is recognized and realized in current year financials. This strategy is consistent with the company's policy on Derivative Risk Management.

[If student used forward contract must allow disclose following.]
At year-end the Company had approximately $22M of forward foreign currency exchange contracts outstanding. These contracts are part of a worldwide program to program to minimize foreign exchange operations and balance sheet exposure. The unsecured contract matures within 12 months is with a bank. The Company is however, exposed to credit loss in the event of non performance by the parties to the contract. The Company evaluates the creditworthiness of the counterparties' financial condition and does not expect default by the counterparties.

Solution to question #5. See question.
12/31/x1 DISCLOSURE IN FINANCIALS - Status of Project known ; Bid is accepted

Off-Balance Sheet Risk (Consulting FASB #105 & #119)
At December 31, x1, the Company has been awarded a significant contract with a client in Hamburg, Germany. Receipt of payment for the project will occur on January 15, x2. To minimize against foreign exchange fluctuations associated with the receivable, the company has entered into an anticipatory hedging strategy involving [options / forward contract]. The gain or loss associated with the strategy will be used to offset the cash flows from the project.

Solution to question #6.See question.
Journal Entries to record put strategy. DM is increasing against the US dollar. Status of contract unknown.

Dec1, 19x1
	Put options		292,000
		Cash		292,000
To record purchase of 320 contract of 125,000 DM put options exercisable at $.5450

Dec 31, 19x1
	Recognized loss on put options		212,000
		Put options		212,000
To mark to market the 320 contracts of DM put options purchased on 12/1/x1. Loss was determined by the closing price (5450 strike price of .20) of the same size contracts trading on the CME on 12/31/x1.

Journal Entries to record forward strategy. DM is increasing against the US dollar. Status of contract unknown. Please note that a gain or loss on a forward contract cannot be deferred as Statement No. 52 allows as it does not meet the following two conditions: 1) The foreign currency transaction is designated as, and is effective as, a hedge of a foreign currency commitment. 2) The foreign currency commitment is firm.

Dec 1, 19x1
	Contract Receivable (fixed)		21,620,000
	Discount on forward contract		332,000
		Contract Payable (fc)		21,952,000
To record fixed receivable of $21,620,000 (forward rate of .5405) from broker and to record a liability of 40,000,000 DMs payable to broker on third in January. To enter into this agreement a fee of $332,000 was paid.

Dec 31,19x1
	Recognized Exchg. Loss		68,000
		Contract payable (fc)		68,000
To mark payable to broker to DM spot rate of .5505.

	Amortization Expense		166,000
		Discount on forward		166,000
To record amortization of 1/2 of forward premium.

Solution to question #7 A. See question.
Journal Entries to record put strategy. DM is increasing against the US dollar. Nicoll finds out that they have been awarded the construction project on December 20, x1.

Dec 1, 19x1
	Put options		292,000
		Cash		292,000
To record purchase of 320 contract of 125,000 DM put options exercisable at $.5450

Dec 31, 19x1
	Deferred loss on put options		212,000
		Put options		212,000
To mark to market the 320 contracts of DM put options purchased on 12/1/x1. Loss was determined by the closing price (5450 strike price of .20) of the same size contracts trading on the CME on 12/31/x1.

Journal Entries to record forward strategy. DM is increasing against the US dollar. Nicoll finds out that they have been awarded the project on December 20, x1. According to company policy, Nicoll will recognize revenue when it ships its products to the German client on January 3, x2.

Dec 1, 19x1
	Contract Receivable (fixed)		21,620,000
	Discount on forward contract		332,000
		Contract Payable (fc)		21,952,000
To record fixed receivable of $21,620,000 (forward rate of .5405) from broker and to record a liability of 40,000,000 DMs payable to broker in January. To enter into this agreement a fee of $332,000 was paid.

Dec 31, 19x1
	Exchange Loss - deferred		68,000
		Contract payable (fc)		68,000
To mark payable to broker to DM spot rate of .5505.

	Amt Expense - deferred		166,000
		Discount on forward		166,000
To record amortization of 1/2 of forward premium.

Jan. 3, 19x2
	Accounts Receivable (fc)		22,040,000
		Sales Hamburg client		22,040,000
To record shipment of goods to Hamburg client. At January 3, x2, spot rate of .5510.

Jan 15, 19x2
	Cash (fc)		20,080,000
		Exchange gain		40,000
		Accounts Receivable (fc)		22,040,000
To record receipt of payment of 40,000,000 DM at spot rate of .5520 from Hamburg client.

	Recognized Loss on put options		80,000
		Put options		80,000
To write off the balance in the put option account on .5450 DM's as they are worthless.

	Sales - Hamburg client		212,000
		Deferred loss on puts		212,000
To reclassify the deferred option put loss as an adjustment to the sales revenue.

Jan. 3, 19x2
	Accounts Receivable (fc)		22,040,000
		Sales - Hamburg client		22,040,000
To record shipment of goods to Hamburg client. At January 3, x2, spot rate of .5510.

Jan 15, 19x2
	Cash		21,620,000
		Contract Receivable (fixed)		21,620,000
To record receipt of US dollars from broker determined on Dec. 1, x1.

	Cash (fc)		22,080,000
		Exchange gain		40,000
		Accounts Receivable (fc)		22,040,000
To record receipt of payment of 40,000,000 DM at spot rate of .5520 from Hamburg client.

	Contract payable (fc)		22,020,000
	Exchange Loss		60,000
		Cash		22,080,000
To record settlement of forward contract with the exchange broker (at spot rate of .5520). Note, exchange gain'loss do not perfectly offset on the above two entries because A/R was not recorded in the B/S until January 3, 19x2.

	Sales - Hamburg client		400,000
		Discount on forward contract		332,000
		Deferred exchange loss		68,000
To reclassify the premium and the deferred exchange loss as adjustments to the sales revenue to Hamburg client.

Author's note, the total loss associated with the forward contract does not equal the loss estimated in question #3. This is due to Nicoll's revenue recognition policy. Had Nicoll recognized the sale on Dec 1, x1, loss on forward would have been what is reported in the table.

A. No journal entry changes are required, as Nicoll is recognizing the gain or loss on put option, forward/futures contract in current period. The sale is not recorded as a firm commitment at year end. No hedge accounting used. [If option put strategy has been chosen by student, they did not mark to market this financial instrument through using FASB #124 logic, it must be done at year end according to the Exposure Draft.]

B. Journal entries would be required to recognize the deferred gain or loss on put option, or forward/futures contract in comprehensive income. When the transaction occurs (shipment of goods to Hamburg), Nicoll will recognize in current earnings the total amount of fair value changes that have accumulated in other comprehensive income. The adjustments to comprehensive income would be disclosed on the income statement and balance sheet of Nicoll's 19x1 year end financials as the firm commitment would be set up as liability and the "receivable from this as an asset."

Finacial Instruments
The following table presents the carrying amounts and the estimated fair values of financial instruments at December 31, 19x1; ( ) denotes liabilities:

The fair values of the items listed in the above table were obtained quoted market prices or obtaining quotes from dealers.

The Table below summarizes by major currency the notional amounts of foreign currency forward contracts in US dollars. The counter-currency for the majority of the contracts are cross-currency with one foreign currency traded for another. Foreign currency amounts are translated at rates current at the reporting date. The "buy" amounts represent the US dollare equivalent of commitments to purcahse foreign currencies, and the "sell" amounts represent the US dollar equilvalent of commitments to sell foreign currency forward agreements maturing in x2. The market risk related to foreign currency forward contracts is substantially offset by changes in the valuation and cash flows of the underlying positions hedged.

Balance Sheet Risk (Consulting FASB #105 & #119)
As of December 31, x1, the Company has been awarded a significant contract with a client in Hamburg, Germany. Receipt of the payment for the contract is anticipated to be received in mid-January, x2. To minimize against the foreign exchange fluctuations associated with the bid, the company has entered into an anticipatory hedging strategy involving the purchase of [options or a forward contract]. The total gain or loss associated with the firm's strategy is a [loss of $212,000 on the put options purchased to hedge or $68,000 on the forward contract]. The gain/loss portion associated with the [chosen] strategy is recognized and realized in current year financials in comprehensive income. Total loss/gain with the strategy is not known at this time. This strategy, though, is consistent with the company's policy on Derivative Risk Management.

	Carrying Amount	Fair Value
Marketable securities:
Current Long-term
Other investments
Foreign currency forwards	21,620,000	21,454,000
DM options	292,000	80,000
Steel options

	Buy	Sell
British pound
German mark		22,020,000
Others
Total	0	22,020,000