Financial Management 102

Topic: DERIVATIVES – HEDGING OF A NET INVESTMENT IN FOREIGN ENTITY

On December 31, 2018, YG Entertainment Co., the parent of the 100% owned Korean subsidiary
expected the W (won) to weaken by the end of 2019. Accordingly, YG Entertainment Co. the parent
contracted with foreign exchange trader on December 31, 2018, to sell W 2 300 000 (the subsidiary net
asset position at that date) in 365 days at the forward rate of P .435.

The following direct exchange rates are as follows:

12/31/18 12/31/19
(the inception date) (the expiration date and
financial reporting date)
Spot Rate P .440 P .400
Forward Rate (selling forward) P .435 P .400

The January 1, 2019 balance of translation reserved (cumulative) – debit amounted to P 129 000 and
translation reserve loss for 2019 of 100 000.

The question is, what amount to be charged to foreign exchange gain or loss on forwards contract at
December 31, 2019?

SOLUTION:

12/31/2018: Original forward rate (365 days) P .435

12/31/2019: Spot Rate P.400
Foreign exchange gain per unit P .035
Multiplied by: number of foreign countries 2 300 000
Foreign Exchange Gain- OCI P80 500

A hedge of foreign currency exposure of a net investment in a foreign operation may result in a gain or a
loss. Assuming the hedge is designated as such, the gain or loss should be reported in the same way that
the translation adjustment is reported to the extent that the hedge is effective. Therefore, the gain or
loss traceable to hedge effectiveness will be reported as a component of equity.

FORWARD AND FUTURE CONTRACTS

SM Entertainment Co. operates a five-star hotel. The entity makes very detailed long-term planning. On
October 1, 2019, the entity determined that it would need to purchase 8,000 pieces of album of Red
Velvet: ReVe Festival on January 1, 2021.

Because of the fluctuation in the price of Red Velvet: ReVe Festival, on October 1, 2019, the entity
negotiated a forward contract with a bank to purchase 8,000 pieces of album of Red Velvet: ReVe
Festival on January 1, 2021 at a price of P 9 600 000.
The price of Red Velvet: ReVe Festival was P 1 200 per piece on October 1, 2019. This forward contract
was designated at a cash flow hedge.

The entity is predicting a drop in worldwide album prices between October 1, 2019, and January 1, 2021.

On December 31, 2019, the price of an album of Red Velvet: ReVe Festival is P 1 500. On December 31,
2020 and January 1, 2021, the price of an album of Red Velvet: ReVe Festival is P 1 000.

The appropriate discount rate throughout this period is 10%/ the present value of 1 at 10% is .91.

The question is:

(a) What is the notional value of the forward contract?

Answer: The notional figure is 8 000 pieces and the notional value is 8 000 pieces’ times the underlying
fixed price of P 1 200 per piece or P 9 600 000.

(b) what is the derivative asset or liability on December 31, 2019?

Answer:

Market Price – December 31, 2019 1 500

Underlying fixed price 1 200
Derivative asset 300
Forward contract receivable (8 000 x 300) 2 400 000
Present value of derivative asset (2 400 000 x .91) 2 184 000

The present value of P 2 184 000 is recognized as forward contract receivable on December 31, 2019
because the amount is collectible on January 1, 2021, one year from December 31,2019.

Forward contract receivable 2 184 000

Unrealized gain – forward contract 2 184 000

(c) what is the derivative asset or liability on December 31, 2020?

Answer:

Market Price – December 31, 2020 1 000

Underlying fixed price 1 200
Derivative liability 200
Forward contract receivable (8 000 x 200) 1 600 000

Unrealized loss – forward contract 1 600 000

Forward contract payable 1 600 000

Unrealized gain – forward contract 2 184 000

Forward contract receivable 2 184 000

Future Contracts
On February 25, 2020, Mr. Yook Sungjae bought a BTOB Silverlight futures contract to Cube
Entertainment that cost him P 538 000, for this he had to pay an initial margin of P 43, 040 to his broker,
Lim Hyunsik. Each Silverlight futures contract is for the delivery of P 200. On March 15, 2020, the index
closed at 2 720. How much profit/loss did he made?

Answer:

Mr. Yook bought one futures contract costing him P538 000. At a market price of delivery of 200, this
means that he paid 2 690 (538 000/200) per Silverlight futures. On the futures expiration day, the future
price coverages to the spot price. If the index closed at 2 720 this must be the futures closes price as
well. Hence, he would have made of profit of P 6000 (2 720 less 2690).

DIVIDEND REINVESTMENT PLANS

Park Jimin owns 1,000 shares in a real estate investment trust (REIT) and participates fully (100%) in the
BigHit Entertainment Company’s dividend reinvestment plan. The REIT declares a dividend of W10/share
payable on December 1. On said date, the market price of the share is W100, and the dividend
reinvestment plan offers a 15% discount. With full participation in the company’s DRIP, how many
additional shares will Jimin be able to purchase in the dividend reinvestment plan?

Answer:

On December 1, Jimin receives a cash dividend of W10,000 (1,000 shares x W10). Jimin fully participates
in the DRIP, thereby reinvesting 100% of her cash dividends into additional shares of the company. On
the payment date, the market share price is W100. With a 15% discount from the DRIP, Jimin is able to
purchase additional shares at a price of W85 (W100 x 0.85).

With a purchase price of W85 and W 10,000 in cash dividends, Jimin will now own an additional
117.6471 shares (W 10,000 / W 85) in the real estate investment trust. Typically, the fractional amount
(0.6471) is carried toward the next dividend payment. Therefore, with the dividend reinvestment plan,
Jimin will own an additional 117 shares.