Zorba

Zorba Company, A us based importer of specialty olive oil, placed an order with a foreign supplier for 500 cases of olive oilat a price of 100 crowns per case. The total purchase price is 50,000 crowns. Relevant exchange rates are as follows:

Call Option Premium
Forward Rate for January 31, Yr 2          Date Spot Rate to Jan. 31 yr 2            strike price $1.00
Dec. 1 Year 1                                                      $1.00                                                $1.08            $0.04
Dec. 31 Year 1                                                    $1.10                                                $1.12           $0.12
Jan. 31 Year 2                                                     $1.15                                               $1.15            $0.15

Zorba Co. has an incremental borrowing rate of 12% (1% per month) and closes the books and prepares financial statements on Dec. 31.

1. Assume the Olive oil was received on Dec 1, Year 1 and payment was made on Jan 31 Year 2. There was no attempt to hedge the exposure to foreign exchange risk. Prepare journal entries to account for this import purchase
2. Assume the olive oil was received on Dec 1 Year 1 and payment was made on October January 31, Year 2. On Dec. 1, Zorba Co entered into a two month forward contract to purchase 50,000 crowns. The forward contract is properly designated as a fair value hedge of a foreign currency payable. Prepare journal entries to account for the import purchase and forign currency forward contract.

4. Option Cash Flow Hedge of a Recognized Foreign Currency Liability

The following schedule summarizes the changes in the components of the fair value of the crown call option with a strike price of $1.00 for January 31, Year 2.
Change                                 Change
Spot       Option  Fair        in Fair   Intrinsic               Time      in Time
Date      Rate       Premium             Value    Value    Value    Value    Value
12/1/Y1                $1.00     $.04        $2,000   –              $0           $2,0001 –
12/31/Y1              $1.10     $.12        $6,000   + $4,000                $5,0002 $1,0002 – $1,000
1/31/Y2                $1.15     $.15        $7,500   + $1,500                $7,500   $03         – $1,000

1 Because the strike price and spot rate are the same, the option has no intrinsic value.  Fair value is attributable solely to the time value of the option.
2 With a spot rate of $1.10 and a strike price of $1.00, the option has an intrinsic value of $5,000.  The remaining $1,000 of fair value is attributable to time value.
3 The time value of the option at maturity is zero.

5. Option Fair Value Hedge of a Foreign Currency Firm Commitment

Firm Commitment                          Option Foreign Currency Option
Spot       Change in            Premium             Change in
Date      Rate       Fair Value           Fair Value           for 1/31/Y2         Fair Value           Fair Value
12/1/Y1                $1.00     $0           –              $.04        $2,000   –
12/31/Y1              $1.10     $(4,950.50)          –$4,950.501        $.12        $6,000   +$4,000
1/31/Y2                $1.15     $(7,500)                –$2,549.50           $.15        $7,500   +$1,500

1 $50,000 – $55,000 = $(5,000) x .9901 = $(4,950.50), where .9901 is the present value factor for one month at an annual interest rate of 12% (1% per month) calculated as 1/1.01.