Ridgeway Inc.'s functional currency is the U.S. dollar.  Ridgeway owns 10,000 shares of London PLC's publicly traded stock and classifies the equity securities as available-for-sale securities.  London PLC is listed only on the London exchange and its share price and dividends are denominated in pounds sterling (£).

As of April 1, 20X0, the London PLC shares are trading at £100 per share (Ridgeway Inc. investment is valued at £1,000,000) and Ridgeway has an unrealized gain of $250,000 in OCI associated with those shares.  Ridgeway wishes to hedge the fair value of its investment in London PLC against adverse changes in the U.S. dollar/£ exchange rate.  On April 1, 20X0, Ridgeway purchased a foreign currency put option from Bank A for $30,000.  The purchased put option allows Ridgeway to put £1,000,000 to Bank A in exchange for $1,000,000 on September 30, 20X0.  Ridgeway designates the purchased put option as a hedge of its risk of changes in fair value of its available-for-sale (AFS) equity portfolio (for £1,000,000) resulting from changes in the U.S. dollar/£ exchange rate.

Assumptions:

Share prices, foreign exchange rates, and fair value of Ridgeway's investment portfolio are as follows:

The change in fair value of the portfolio is attributable to both changes in the exchange rates and market prices.  Set out below are the changes attributable to each:

At June 30 and September 30, the value of the portfolio was £1,050,000.  Note, however, that the notional amount of Ridgeway's hedging instrument was only £1,000,000.  Therefore, subsequent to the increase in the value of the pound (which is assumed to have occurred on June 30), a portion of Ridgeway's foreign currency exchange risk was not hedged.

For the three-month period ending September 30, exchange rates caused the value of the portfolio to decline by $52,500.  Of that amount, only $50,000 was offset by changes in the value of the currency put option.  The difference between those amounts ($2,500) represents the exchange rate loss on the unhedged portion of the portfolio (i.e., the "additional" £50,000 of fair value that arose through increased share prices after entering into the currency hedge).  At June 30, the additional £50,000 of stock value had a U.S. dollar fair value of $45,000.  At September 30, using the spot rate of 0.85:1, the fair value of this additional portion of the portfolio declined to $42,500.

Ridge way will exclude from its assessment of hedge effectiveness the portion of the fair value of the put option attributable to time value.  That is, Ridgeway will recognize changes in that portion of the put option's fair value in earnings but will not consider those changes to represent ineffectiveness.

The fair value, time value, and intrinsic value of the currency put option is as follows:

1.  Dr.  Purchased put option (B/S)
     Cr.  Cash (B/S)
(To record the purchase of the put option in the statement of financial position at fair value)

b)      The journal entries as of June 30, 20X0 would be as follows:

1.  Dr.  Change in time value of put option (P&L)
     Cr.  Purchased put option (B/S)
(To reflect the change in the time value of the put option)

2.  Dr.  Purchased put option (B/S)
     Cr.  Unrealized gain on intrinsic value of option (P&L)
(To record the change in the intrinsic value of the put option)

3.  Dr.  Unrealized loss on AFS portfolio due to exch. rates (P&L)
     Cr.  Other comprehensive income
     Cr.  AFS equity securities (B/S)
(To reflect the change in fair value of the available-for-sale equity security.  The change in fair value attributable to the change in exchange rates is recorded through earnings, the remainder through OCI)

c)      The journal entries as of September 30, 20X0 would be as follows:

1.  Dr.  Change in time value of put option (P&L)
     Cr.  Purchased put option (B/S)
(To record the change in the time value of the put option since the option has reached its exercise date the time value is zero)

2.  Dr.  Purchased put option (B/S)
     Cr.  Gain on intrinsic value of option (P&L)
(To record the change in the intrinsic value of the put option)

3.  Dr.  Cash (B/S)
     Cr.  Purchased put option (B/S)
(To record the net cash settlement of the purchased currency put option)

4.  Dr.  Unrealized loss on available-for-sale portfolio due to exch. rates (P&L)
     Cr.  AFS equity securities (B/S)
(To reflect the change in fair value of the hedged portion of the available-for-sale equity portfolio attributable to the hedged risk)

5.  Dr.  Other comprehensive income
     Cr.  AFS equity securities (B/S)
(To reflect the change in fair value of the unhedged portion of the available-for-sale equity portfolio)

Observations:

Ridgeway's hedging objective was to lock in the U.S. dollar value of the foreign-currency-denominated investment at the spot exchange rate that existed at April 1, 20X0.  At April 1, 20X0, Ridgeway's investment in London PLC had a carrying value of $1,000,000.

If Ridgeway had not entered into a foreign currency fair value hedge of its investment in London PLC, at September 30, 20X0, its investment would have been carried at $892,500.  The unrealized loss during this period would have reflected the weakening of the U.S. dollar against the pound sterling, offset in part by an increase in London PLC's stock price over the period between April 1, 20X0 and September 30, 20X0.

However, Ridgeway hedged against the risk of the U.S. dollar weakening against the pound sterling to the extent of a £1,000,000 notional amount.  As a result, the loss in value of the investment in London PLC attributable to foreign exchange movements was offset (net of the option premium paid) by gains on the derivative hedging instrument.  Specifically, the purchased put option paid Ridgeway $150,000 in cash.  After netting those proceeds with the cost of the option, the positive cash flows resulting from the put option was $120,000.  Therefore, on September 30, 20X0, as a result of the hedging instrument, Ridgeway had assets of $1,012,500 (Investment: $892,500, Cash: net $120,000) compared with the potential unhedged position which would have been $892,500.