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Quiz for Week 6
ACCT 5341
1. Penman C6.2
The historical earnings growth rate for the S&P 500 companies has been about 8.5%. Yet the
required growth rate for equity investors is considered to be about 12%. Can you explain the
inconsistency?
C6.2. The historical 8.5% growth rate that is often quoted is the ex-dividend growth rate.
It ignores the fact that earnings were also earned by investors from reinvesting dividends
(in the S&P 500 stocks, for example) that were typically 40% of earnings. The cumdividend rate is about 12%.
2. File 1 Question 17 from Week 6 (With Answer)
Distinguish and relate the concepts of hedge ratio, Delta, and Theta. Why to option writers
prefer high Theta values?
See “Managing Financial Risk” Page 106.
An option's delta is also called its hedge ratio. It depicts the elasticity of the premium
(price of the option) vis-a-vis price movements of the underlying asset of liability.
Technically is is the partial derivative of the premium with respect to the underlying. It is
the C/S ratio in the Black-Scholes model. For the call option the range is [0<=P<=1] and
the put option [-1<=P<=0].
See Page 107. An option’s theta measures the change in the option premium with respect
to passage of time. Generally it is negative. Option writers prefer high thetas because the
value of the option falls rapidly as it approaches expiration.
3. What factors will increase the value of a purchased call option? Mention at least three
factors that increase value. (With Answer)
Call options tend to increase in value when the expiration date is increased (thus increasing
time value) and the volatility of the underlying increases (also increases time value). Volatility is
measured by the s parameter in the Black-Scholes model on Page 78 of “Managing Financial
Risk.” In terms of this formula, the following factors increase the value of a purchased call
option:



A longer time (t) before expiration
Greater volatility (s) of the underlying
Lower exercise (strike) price (X)
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Question 4
Quiz 6 Corporation enters into a purchase contract to buy 100,000 bu. of a commodity for $10 per bu. of June 30. It
plans to sell the commodity on July 31 at exit value based on an unknown exit value. The company acquires a
forward contract (Call it Forward Contract 1) that expires on June 30 to lock in the net entry value of the purchase at
$1,000,000. Assume hedge effectiveness is on the 80%-125% Delta test each time the forward contract is adjusted
to fair value.
Hint: Basis adjustment occurs when hedges are dedesignated and/or no longer are sufficiently effective.
In addition, the Quiz 6 Corporation enters into a forward contract (call it Forward Contract 2) on June 30 to lock in a
$90,000 profit on a July 31 sale of the inventory it purchases on June 30. The forward price of the hedge is the
$1,070,000 June 30 exit value and the firm receives or pays out the difference between this forward value and the
July 31 spot price of exit value. The denominator of the Delta ratio is based upon this one month change in exit
values. The numerator is the change in the value of Forward Contract 2 in July.
The ex post outcomes that were not known in advance are as follows:
Date
Item
Entry Value
Exit Value
Jan. 01
Mar. 31
June 30
July 31
Commodity
Commodity
Inventory
Inventory
$1,000,000
$950,000
$970,000
$890,000
$1,100,000
$1,050,000
$1,070,000
$980,000
Forward
Contact 1
Value
$0
$50,000 asset
$20,000 asset
$0
Forward
Contact 2
Value
$0
$90,000 asset
When filling in account titles, choose from the following account titles not shown in the journal below:
Required: Fill in missing account names, amounts in the debit/credit cells, and the
current balances. Account for the Delta outcomes where appropriate.
Assume that it’s possible to carry a negative cash balance. Also note that
ineffectiveness can lead to gains as well as losses.
19X5
Jan. 01
Jan. 01
Mar. 31
June 30
June 30
June 30
June 30
Purchase commitment
Cash
-Actually purchase contracts are not even booked
Forward contract 1
Cash
-To record acquisition of the Forward Contract 1.
Forward contract 1
P&L
Firm commitment
-To record change in value of Forward Contract 1.
Delta = 100%
Debit
0
Credit
0
0
0
0
0
0
50,000
50,000
0
(50,000)
20,000
30,000
0
(20,000)
20,000
20,000
20,000
0
1,000,000
1,000,000
(980,000)
0
0
0
0
50,000
Firm commitment
P&L
Forward contract 1
-To record change in value of Forward Contract 1.
Cumulative Delta = 67% = 20,000/30,000
The entry above assumes hedge accounting is no
longer allowed. Therefore basis is adjusted now.
50,000
Cash
Forward contract 1
-To record cash settlement of Forward Contract 1
Commodity inventory
Cash
-To record the honoring of the purchase contract.
Forward contract 2
Cash
-Entered in to hedge of a forecasted sale on July 31
20,000
Current
Balance
1,000,000
0
3
July 31
July 31
July 31
July 31
July 31
Forward contract 2
P&L
OCI
-To record change in value of Forward Contract 2.
One-Month Cumulative Delta = 100% = 90,000/90,000
Based upon exit value change from June 30-July 31.
Cash
Forward contract 2
-To record cash settlement of Forward Contract 2
Cost of goods sold
Commodity inventory
-To record the cost of goods sold
Cash
Sales
-To record the sale at exit value
Sales
OCI
P&L
Cost of goods sold
Retained earnings
-To close the books on July 31
90,000
0
(90,000)
90,000
(20,000)
(90,000)
90,000
(890,000)
0
1,000,000
1,000,000
0
980,000
90,000
(980,000)
1,000,000
90,000
0
0
0
0
(90,000)
90,000
1,000,000
980,000
980,000
90,000
20,000
Added Requirements
The firm did not make a profit of $100,000 due to ineffectiveness of one or both hedges. If you
view the net change in retained earnings, identify what portion of the change was due to the
following:
Sales – Cost of Goods Sold
Settlement of Forward Contract 1
Settlement of Forward Contract 2
Net change in cash (and retained earnings)
Perfectly
Effective
Hedges
-$ 20,000
$ 30,000
$90,000
$100,000
Actual
Ineffectiveness
Outcomes
-$20,000
$20,000
$90,000
$90,000
Discuss the above hedging outcomes in a way that would explain to management why the
hedged profit of $100,000 was not achieved in the actual outcome.
Discussion
The company failed to lock in the $100,000 profit due to the ineffectiveness of Forward Contract
1 that was a fair value hedge of the value of the purchase commitment. The derivative should
have paid off $30,000, but only paid off $20,000. Derivative Contract 2 was a perfectly effective
cash flow hedge of cash flow across the month of July.