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Fair Value Hedge of Jensen Company

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On September 1, 2004, Jensen Company received an order to sell a machine to a customer in Canada at a price of 100,000 Canadian dollars. The machine was shipped and payment was received on March 1, 2005. On September 1, 2004, Jensen Company purchased a put option giving it the right to sell 100,000 Canadian dollars on March 1, 2005 at a price of $80,000. Jensen Company properly designates the option as a fair value hedge of the Canadian dollar firm commitment. The option cost $2,000 and had a fair value of $2,300 on December 31, 2004. The fair value of the firm commitment is measured through reference to changes in the spot rate. The following spot exchange rates apply:

US Dollar per
Date Canadian Dollar

September 1, 2004 $0.80
December 31, 2004 0.79
March 1, 2005 0.77

Jensen Company's incremental borrowing rate is 12 percent. The present value factor for two months at an annual interest rate of 12 percent (1 percent per month) is 0.9803.

1. What was the net impact on Jensen Company's 2004 income as a result of this fair value hedge of a firm commitment?

a. -0-.
b. $680.30 decrease in income.
c. $300 increase in income.
d. $980.30 increase in income.

2. What was the net impact on Jensen Company's 2005 income as a result of this fair value hedge of a firm commitment?

a. -0-.
b. $1,319.70 decrease in income.
c. $77,980.30 increase in income.
d. $78,680.30 increase in income.

3. What was the net increase or decrease in cash flow from having purchased the foreign currency option to hedge this exposure to foreign exchange risk?

a. -0-.
b. $1,000 increase in cash flow.
c. $1,500 decrease in cash flow.
d. $3,000 increase in cash flow.

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This solution is comprised of a detailed explanation which indicates how to answer problems related to net impact and a net change in cash flows. Reasoning is provided to illustrate which option is correct and why.

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1. What was the net impact on Jensen Company's 2004 income as a result of this fair value hedge of a firm commitment?
a. -0-.
b. $680.30 decrease in income.
c. $300 increase in income.
d. $980.30 increase in income.

The value of option as on 31 December, 2004 = $2300
He value of option on Sept 1, ...

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