EXERCISES

Forward Contracts
1. Hedging is used to capitalize on foreign currency exchange rate fluctuations.
2. The hedge of a foreign currency payable or receivable results in the manager
not knowing the amount of cash that will be paid or received.
3. The risk from foreign currency exchange rate fluctuations can occur both before
and after the transaction.
4. A foreign currency forward contract is an agreement to exchange currency units
at a later date at an agreed exchange rate.
5. The forward exchange rate is the currency exchange rate predicted to exist at a
future date.
6. The forward exchange rate is the known future value of the foreign currency.
7. Regardless of the ultimate exchange rate that exists between two currencies, a
forward contract requires the two parties to exchange currencies.
8. Entering into a foreign currency forward contract results in the manager knowing
the amount of cash that will be given or received with certainty.
9. A foreign currency forward contract can only be acquired in predetermined
number of foreign currency units.
10. The foreign currency forward exchange rate will always be greater than the spot
rate.
11. Foreign currency forward contracts are recognized on the balance sheet at their
fair value while foreign currency option contracts (for guidance refer to
discussions in option contracts) are recognized at the amount paid for the
contract.
12. Generally a journal entry is not required at the date a foreign currency forward
contract is created.
13. The fair value of a foreign currency forward contract at a balance sheet date is
based on the difference between the forward exchange rate and the spot rate at
that date.
14. The foreign currency forward exchange rate and the spot rate become the same
at the date the forward contract matures.
15. Gains and losses resulting from a receivable or payable hedge with a foreign
currency forward contract are placed in Other Comprehensive Income until the
transaction occurs.
16. The recording of an inventory purchase transaction will be different when
hedged with an option contract as compared to when it is hedged with a forward
contract.
17. A foreign currency commitment exists when an entity enters into an agreement
to buy or sell goods denominated in a fixed number of foreign currency units at a
future date.
18. If management does not hedge a purchase commitment in a foreign currency,
the company is exposed to exchange rate fluctuation risk from the date the
purchase commitment occurs until the transaction date.
19. The existence of a foreign currency purchase or sales commitment requires the
creation of a foreign currency commitment.
20. The gain or loss or a foreign currency commitment is offset by a loss or gain on
a purchase or sales commitment.
21. When a company hedges a foreign currency commitment, it has two executory
commitments: one for the hedge and one for the underlying purchase or sale
transaction.
22. Gains and losses on a foreign currency commitment are recognized as gains or
losses on the income statement in the period when the underlying transaction
occurs.
23. When recording the creation of a foreign currency commitment established with
a forward contract, the hedge is recorded using the forward exchange rate that
exists on that date.
24. At an intervening balance sheet date of a foreign currency commitment created
with a forward contract, the gain or loss on the hedge is determined by
comparing the forward rate at the balance sheet date with the spot rate at the
balance sheet date.
25. It is possible to hedge a foreign currency transaction that is forecast to occur
even though there is no transaction or even an agreement to a transaction.
26. Gains or losses that incur in conjunction with the hedge of a forecasted foreign
currency transaction impact the income statement in the period of exchange rate
fluctuation.
27. The gain or loss resulting from the hedge of a forecasted foreign currency
transaction is placed in other comprehensive income and it never becomes part
of net income.
28. There is no journal entry required for the initiation of a foreign currency forward
contract created as a hedge of a forecasted transaction.
29. A forward contract used to hedge a foreign currency forecasted transaction does
not have to be revalued at the balance sheet dates because there is no
underlying transaction.
30. It is possible to have a negative fair value for a foreign currency forward contract
used to hedge a forecasted transaction.
31. A speculative foreign currency contact exists when an entity enters into an
agreement to buy or sell foreign currency in the future at a known price when
there is no underlying transaction or commitment to a future transaction, or
forecasted future transaction.

Answers:
1. F, Hedging is the use of a financial instrument contract to eliminate exchange
rate fluctuation risk
2. F, A hedge establishes a fixed exchange rate between currencies so the amount
of cash to be paid or received is known
3. T
4. T
5. T
6. F, The forward exchange rate is the estimated future value of a currency based
on the market’s expectations
7. T
8. T
9. F, A foreign currency forward contract results from negotiations between an
individual buyer and seller of foreign currency and can be for any number of
currency units and the exchange can occur at any agreed date.
10. F, The relationship between for forward exchange rate and the spot rate
depends on the market’s expectations
11. F, Both foreign currency forward contracts and option contracts are
recognized on the balance sheet at their fair value.
12. T
13. F, The fair value of a forward contract is based on the difference between the
forward exchange rate at the date the contract is created and the forward
exchange rate at the balance sheet date.
14. T
15. F, Gains and losses on the hedge of a payable or receivable are immediately
recognized to offset the loss or gain on the receivable or payable.
16. F, The purchase transaction is the same regardless of whether the transaction is
hedged or not whether it is hedged with a forward contract or an option contract.
17. T
18. T
19. F, If a foreign currency commitment is not hedged, the company accepts the risk
of currency rate fluctuation from the date of the purchase or sales commitment
until the transaction date.
20. T
21. T
22. F, Gains and losses on a foreign currency commitment are recognized as an
adjustment to sales, in the case of a sales transaction, or the asset value, in the
case of a purchase transaction, at the date of the underlying transaction.
23. F, A foreign currency commitment is an executory contract. Given that cash is
not exchanged at the date the hedge is created with a forward contract, there is
no entry with regard to the foreign currency commitment.
24. F, The gain or loss on the forward contract is based on the difference between
the forward contract that existed at the date the contract was established and the
forward rate at the balance sheet date.
25. T
26. F, Gains and losses on a forecasted foreign currency transaction are not
included in income because it cannot be offset against the gain or loss resulting
from a transaction or the commitment to a transaction. Gains and losses for
forecasted foreign currency transaction hedges are placed in other
comprehensive income until a transaction occurs.
27. F, The gain or loss resulting from the hedge of a forecasted foreign currency
transaction is placed on the income statement in the period as when the
underlying transaction affects the income statement.
28. T
29. F, The forward contract must be revalued and the change in market value placed
into other comprehensive income until a commitment occurs or the underlying
transaction occurs.
30. T
31. T

Option Contracts
1. A foreign currency option contract is an agreement in which the contract’s writer
guarantees the holder that the holder may purchase or sell the foreign currency
at a known price (strike price) but the holder is not obligated to purchase or sell
the currency if the exchange rate is not favorable.
2. When a manager enters into a foreign currency option contract, the company is
obligated to exchange currencies at an agreed price on a future date.
3. Foreign currency option contracts are only created in fixed sizes.
4. Foreign currency option contracts are individually negotiated between the two
parties.
5. The strike price of a foreign currency option contract is the amount the holder
must pay to enter into the contract.
6. Foreign currency option contracts where the holder has the right to purchase the
currency is termed a call option
7. Foreign currency put options are more risky than foreign currency call options.
8. Foreign currency option contracts where the holder has the right to sell the
currency are termed a put option.
9. The premium for a foreign currency option contract always increases as the
strike price decreases.
10. A foreign currency option contract is said to be in the money when the currency’s
spot rate is less than the put strike price or more than the call strike price.
11. A foreign currency option contract is said to be out of the money when the
currency’s spot rate is more than the put strike price or less than the call strike
price.
12. Foreign currency forward contracts and option contracts can each result in gains
and losses to the holder as a result of foreign currency exchange rate
fluctuations.
13. A journal entry is required at the date an option contract is purchased
14. The holder of an option contract has an unlimited potential loss on the option
contract.
15. The writer of an option contract has an unlimited potential loss on the option
contract.
16. The writer of an option contract has an unlimited potential gain on the option
contract.
17. The holder of an option contract has an unlimited potential gain on the option
contract.
18. An option contract creates a requirement that the holder and the writer of the
option contract exchange currencies at a future date.
19. The strike price for a foreign currency and the currency’s spot rate will be the
same at the date the option contract matures.
20. The change in the fair value of the derivative (forward contract or option
contract) used to hedge a foreign currency commitment does not have to be
recognizes because a transaction has not yet occurred.
21. The hedge of a foreign currency commitment with an option contract requires a
journal entry for the option contract at the date the hedge is established but it
does not require a journal entry for the purchase or sales commitment.
22. There is no journal entry required for the initiation of a foreign currency option
contract created as a hedge of a forecasted transaction.
23. An option contract used to hedge a foreign currency forecasted transaction has
to be revalued at the balance sheet dates even though here is no underlying
transaction.
24. It is possible to have a negative fair value for a foreign currency option contract
used to hedge a forecasted transaction.

Answers:
1. T
2. F, An option contract gives the holder the right to exchange currency but not the
obligation
3. T
4. F, Foreign currency option contracts are fixed contracts traded on organized
exchanges.
5. F, The strike price is the price at which the option writer agrees to exchange
currency with the holder. The amount the holder pays to enter into the contract
is the premium.
6. T
7. F, Call and put options define whether the holder is purchasing or selling the
foreign currency. The terms are not related to the risk of the option contract
8. T
9. F, The premium will increase as the strike price decreases for a call option but
will decrease as the strike price decreases for a put option
10. T
11. T
12. F, Foreign currency forward contracts can result in a gain or a loss to the holder.
However, the foreign currency option contract can only result in a gain to the
holder.
13. T
14. F, The holder of the option contract has a loss limited to the amount of the
premium paid to the option writer.
15. T
16. F, The writer of an option contract has a gain limited to the amount of the
premium received from the holder.
17. T
18. F, An option contract permits the holder to exchange currencies with the writer
but does not require the exchange. The holder will exchange currencies if the
exchange rate in the option contract is favorable when compared to the market
exchange rates.
19. F, The strike price and the spot rate do not have to be equal at any time.
20. F, The change in value of the derivative must always be recognized but, in the
case of a foreign currency commitment, it is offset with a recognized change in
value of the purchase or sales commitment.
21. T
22. F, The premium paid to the writer of the contract must always be recorded.
23. T
24. F, A foreign currency option contract provides the right but not the obligation to
exchange currencies. As a result, the option contract can have a positive value
or a value of zero.

Conceptual Multiple Choice Questions

1. Which of the following statements is not correct with regard to a foreign currency
option contract?
a. The holder of the contract has the potential for an unlimited gain on the
option contract
b. There are two parties to the contract, the writer and the holder
c. The writer and the holder are required to exchange currency at the
contract’s maturity
d. The writer of the contract receives payment at the contract initiation

2. Which of the following terms is the predetermined rate at which currencies can
be exchanged in a foreign currency option contract?
a. Strike price
b. Forward rate
c. Spot rate
d. Premium

3. Which of the following terms pertains to a foreign currency option contract where
the holder has the right to purchase foreign currency?
a. Put
b. Strike price
c. Call
d. Forward rate

4. Which of the following terms pertains to a foreign currency option contract where
the holder has the right to sell foreign currency?
a. Put
b. Strike price
c. Call
 d. Forward rate

5. When the strike price exceeds the spot rate for a foreign currency call option
contract, the contract is said to be which of the following?
a. In the money
b. On the money
c. Out of the money
d. Next to the money

6. When the strike price exceeds the spot rate for a foreign currency put option
contract, the contract is said to be which of the following?
a. In the money
b. On the money
c. Out of the money
d. Next to the money

7. When the strike price is less than the spot rate for a foreign currency put option
contract, the contract is said to be which of the following?
a. In the money
b. On the money
c. Out of the money
d. Next to the money

8. When the strike price is less than the spot rate for a foreign currency call option
contract, the contract is said to be which of the following?
a. In the money
b. On the money
c. Out of the money
d. Next to the money

9. Which of the following statements is correct with regard to accounting for a

foreign currency purchase on credit and an accompanying foreign currency
option contract?
a. It is necessary to recognize the foreign currency option contract in the
financial records at the date the contract is created
b. It is not necessary to account for the accounts payable because the
company has hedged the liability with the option contract
c. The accounting for the accounts payable is altered because the company
purchased the option contract
d. Accounting for the change in the value of the accounts payable at the
balance sheet date is based on the difference between the spot rate and
the strike price of the option contract

10. Which of the following statements is correct with regard to a foreign currency
option contract?
a. The option contract requires the holder and the writer to exchange
currencies at a future date
b. The option contract writer has the possibility of unlimited gains on the
contract
c. The option contract holder’s losses are limited to the amount of premium
paid to the contract writer
d. The option strike price is the minimum exchange rate that will exist when
the option contract matures

11. Which of the following statements is correct with regard to a foreign currency
commitment hedged with an option contract?
a. The foreign commitment hedge period ends on the date the underlying
transaction is settled
b. The gain or loss on the foreign currency commitment option contract is
offset by losses or gains pertaining to the sales amount or the recognized
asset value at the transaction date
c. The option contract is valued at the difference between the forward
exchange rate and the spot rate
d. The gain or loss on the forward contract is recognized only on the date of
the underlying transaction

12. Which of the following statements is not correct with regard to a forecasted
foreign currency transaction hedged with an option contract?
 a. The gain or loss due to fluctuating exchange rates is initially recognized
in other comprehensive income
b. A journal entry is not required at the time the hedge is established
c. The hedge of a forecasted foreign currency transaction becomes the
hedge of a receivable or payable at the transaction date
d. The option must be revalued at the balance sheet date

Answers:
1. c
2. a
3. c
4. a
5. c
6. a
7. c
8. a
9. a
10. c
11. b
12. b