On March 1, 2011, Mattie Company received an order to sell a machine to a customer in England at a price of 200,000 British pounds. The machine was shipped and payment was received on March 1, 2012. On March 1, 2011, Mattie purchased a put option giving it the right to sell 200,000 British pounds on March 1, 2012 at a price of $380,000. Mattie properly designates the option as a fair hedge of the pound firm commitment. The option cost $2,000 and had a fair value of $2,200 on December 31, 2011. The following spot exchange rates apply: Mattie's incremental borrowing rate is 12 percent, and the present value factor for two months at a 12 percent annual rate is .9803. What was the net impact on Mattie's 2011 income as a result of this fair value hedge of a firm commitment?
A) $1,800.00 decrease.
B) $1,760.60 decrease.
C) $2,240.40 decrease.
D) $1,660.40 increase.
E) $2,240.60 increase.

Question

On March 1, 2011, Mattie Company received an order to sell a machine to a customer in England at a price of 200,000 British pounds. The machine was shipped and payment was received on March 1, 2012. On March 1, 2011, Mattie purchased a put option giving it the right to sell 200,000 British pounds on March 1, 2012 at a price of $380,000. Mattie properly designates the option as a fair hedge of the pound firm commitment. The option cost $2,000 and had a fair value of $2,200 on December 31, 2011. The following spot exchange rates apply:  Mattie's incremental borrowing rate is 12 percent, and the present value factor for two months at a 12 percent annual rate is .9803. What was the net impact on Mattie's 2011 income as a result of this fair value hedge of a firm commitment?
A) $1,800.00 decrease. 
B) $1,760.60 decrease. 
C) $2,240.40 decrease. 
D) $1,660.40 increase. 
E) $2,240.60 increase.

Quizplus · Accepted Answer

The fair value of the put option on December 31, 2011, was $2,200, which resulted in a $200 gain. However, the spot exchange rate on March 1, 2012, was £1 = $1.50, which means that the machine sold for $300,000. Since the option was exercised and Mattie sold £200,000 for $380,000, it received $80,000 more than it would have without the option. Therefore, Mattie's total gain from the fair value hedge was $80,200.

To calculate the impact on 2011 income, we need to determine the carrying amount of the option on December 31, 2011. This is calculated by subtracting the cumulative change in fair value from the initial cost:

$2,000 - ($2,200 - $2,000) = $1,800

This $1,800 loss is recognized in 2011, which decreases Mattie's income. Note that this loss reflects the time value of the option and does not include the $80,200 gain from the option's exercise in 2012.

On March 1, 2011, Mattie Company Received an Order to Sell