Title: Option Contracts
1Option Contracts
2DEFINITIONS
 Call The option holder has the right to buy
the underlying instrument at the calls
exercise (strike) price  Put The option holder has the right to sell
the underlying instrument at the puts exercise
(strike) price
3WRITTEN OPTIONS UNDER FAS 133
 A written option is sold by an "option writer"
who sells options collateralized by a portfolio
of securities or other performance bonds.
Typically a written option is more than a mere
"right" in that it requires contractual
performance based upon another party's right to
force performance. The issue with most written
options is not whether they are covered by FAS
133 rules. The issue is whether they will be
allowed to be designated as cash flow hedges.
Written options are referred to at various points
in FAS 133. For example, see Paragraphs 20c, 28c,
9192 (Example 6), 199, and 396401.. For rules
regarding written options see Paragraphs 396401
on Pages 179181 of FAS 133. Exposure Draft
162B would not allow hedge accounting for
written options. FAS 133 relaxed the rules for
written options under certain circumstances
explained in Paragraphs 396401.  Note that written options may only hedge recorded
assets and liabilities.  They may not be used to hedge forecasted purchase
and sales transactions.
4PURCHASED OPTIONS UNDER FAS 133
 Purchased options are widely used for hedging
 and present some of the biggest challenges for
 hedge accounting rules.
 The major problem is that purchased option values
are often highly volatile relative to value
changes in the hedged item. Traditional Delta
effectiveness tests fail for hedge accounting for
full value.
5OPTION PARTICIPANTS
Call Buyer Pays premium Has the right to
buy Put Buyer Pays premium Has the right to sell
Call Seller Collects premium Has obligation
to sell, if assigned Put Seller Collects
premium Has obligation to buy, if assigned
6IDENTIFYING OPTIONS
 Call or put
 Strike price (exercise price)
 Expiration date
 Underlying instrument
7Option Strategies
 http//www.optionetics.com/education/strategies/st
rategies.asp  Bullish Strategies
 Calls
 Covered Calls
 Vertical Spread
 Bull Call Spread
 Bull Put Spread
 Bearish Strategies
 Buying Puts
 Covered Puts Bear
 Call Spread
 Bear Put Spread
8Delta Hedging
http//biz.yahoo.com/glossary/bfglosd.html Delta
hedge where delta d(Option)/d(spot) Hedge
Ratio A dynamic hedging strategy using options
with continuous adjustment of the number of
options used, as a function of the delta of the
option. Delta neutral The value of the
portfolio is not affected by changes in the value
of the asset on which the options are written.
9Dynamic Hedging
http//biz.yahoo.com/glossary/bfglosd.html
Dynamic hedging A strategy that involves
rebalancing hedge positions as market conditions
change a strategy that seeks to insure the value
of a portfolio using a synthetic put option.
10SPOT/FORWARD PRICES
Price
Forward
Spot
Time
11TIME VALUE / VOLATILITY VALUE
 Time value is the option premium less intrinsic
value  Intrinsic value is the beneficial difference
between the strike price and the price of the
underlying  Volatility value is the option premium less the
minimum value  Minimum value is present value of the beneficial
difference between the strike price and the price
of the underlying
12FEATURES OF OPTIONS
Option Value Intrinsic Value Time Value
 Intrinsic Value Difference between the strike
price and the underlying price, if
beneficial otherwise zero  Time Value Sensitive to time and
volatility equals zero at expiration
13Subparagraph b(c) of Paragraph 63 of FAS 133
 c. If the effectiveness of a hedge with a forward
or futures contract is assessed based on changes
in fair value attributable to changes in spot
prices, the change in the fair value of the
contract related to the changes in the difference
between the spot price and the forward or futures
price would be excluded from the assessment of
hedge effectiveness.
14Subparagraph b(a) of Paragraph 63 of FAS 133
 a. If the effectiveness of a hedge with an option
contract is assessed based on changes in the
option's intrinsic value, the change in the time
value of the contract would be excluded from the
assessment of hedge effectiveness.
15Subparagraph b(b) of Paragraph 63 of FAS 133
 b. If the effectiveness of a hedge with an option
contract is assessed based on changes in the
option's minimum value, that is, its intrinsic
value plus the effect of discounting, the change
in the volatility value of the contract would be
excluded from the assessment of hedge
effectiveness.
16THE IMPACT OF VOLATILITY
A
B
Price
Price
P
P
Time
Time
17Minimum Value
Option Value Risk Free Value Volatility Value
 If the underlying is the price of corn, then the
minimum value of an option on corn is either zero
or the current spot price of corn minus the
discounted riskfree present value of the strike
price. In other words if the option cannot be
exercised early, discount the present value of
the strike price from the date of expiration and
compare it with the current spot price. If the
difference is positive, this is the minimum
value. It can hypothetically be the minimum
value of an American option, but in an efficient
market the current price of an American option
will not sell below its risk free present value.
18INTRINSIC VALUE / MINIMUM VALUE
Option Price
Minimum Value
Strike Price
Intrinsic Value
Underlying Price
19Minimum (Risk Free) Versus Intrinsic
ValueEuropean Call Option
 X Exercise (Strike) Price in n periods after
current time  P Current Price (Underlying) of Commodity
 I PXgt0 is the intrinsic value using the
current spot price if the option is in the money  M is the minimum value at the current time
 MgtI if the intrinsic value I is greater than
zeroValue of Option exceeds minimum M due to
volatility value
20Minimum (Risk Free) Versus Intrinsic
ValueArbitrate for European Call Option
 X 20 Exercise (Strike) Price and Minimum Value
M 10.741  n 1 year with riskfree rate r 0.08
 P (Low) 10 with PV(Low) 9.259
 P 20 such that the intrinsic value now is I
PX 10.  Borrow P(Low), and Buy at 20 9.25910.741
PV(Low)M  If the ultimate price is low at 10 after one
year, pay off loan at P(Low)10 by selling the
commodity at 10.  If we also sold an option for M10.741,
ultimately our profit would be zero from the
stock purchase and option sale.  If the actual option value is anything other than
M10.741, it would be possible to arbitrage a
risk free gain or loss.
21INTRINSIC VALUE / MINIMUM VALUE
Option Price
Minimum Value
Strike Price
Intrinsic Value
Underlying Price
22Minimum Versus Intrinsic ValueAmerican Call
Option
 X Exercise (Strike) Price in n periods after
current time  P Current Price (Underlying) of Commodity
 I PXgt0 is the intrinsic value using the
current spot price if the option is in the money  M 0 is the minimum value since option can be
exercised at any time if the
options value is less than intrinsic value
I.Value of option exceeds M and I due to
volatility value
23Whats Wrong With the BlackScholes ModelWhen
Valuing Options?
 The BlackScholes Model works pretty well for
options on stocks. It does not work well for
interest rate and some commodity options.  The main problem for interest rates is the
assumption that shortterm interest rates are
constant.  The assumption of constant variance is always a
worry when using this model to value any type of
option.  The assumption of normality is always a worry
when using this model for valuing options of any
type.
24LONG OPTION HEDGES
 Fair value hedges
 Marktomarket of the option will generally be
smaller than exposures contribution to earnings  Cash flow hedges
 Changes in intrinsic values of options go to
other comprehensive income to the extent
effective  Remaining changes in option prices goes to
current income
Bounded by the magnitude of the exposures
price changes
25GENERAL RECOMMENDATIONS
 For most static option hedges Exclude time
value from hedge effectiveness considerations  For most fair value hedges Exclude forward
points from hedge effectiveness considerations  For noninterest rate cash flow hedges Assess
effectiveness based on comparisons of forward
prices  For options Consider the FAS Paragraph 167
alternative for minimum value hedging.
26THE RISK BEING HEDGED
 For noninterest rate exposures
 Entities must identify their firmspecific
exposures as hedged items  Differences between firmspecific prices and
hedging instruments underlying variables will
foster income volatility  Prequalifying hedge effectiveness documentation
is required for all crosshedges
27Selected IAS 39 Paragraph Excerpts
 146. 80ltDeltalt125 Guideline.
 147. Assessing hedge effectiveness will depend on
its risk management strategy.  148. Sometimes the hedging instrument will offset
the hedged risk only partially.  149. The hedge must relate to a specific
identified and designated risk, and not merely to
overall enterprise business risks, and must
ultimately affect the enterprise's net profit or
loss.  150. An equity method investment cannot be a
hedged item in a fair value hedge because the
equity method recognizes the investor's share of
the associate's accrued net profit or loss,
rather than fair value changes, in net profit or
loss. If it were a hedged item, it would be
adjusted for both fair value changes and profit
and loss accruals  which would result in double
counting because the fair value changes include
the profit and loss accruals. For a similar
reason, an investment in a consolidated
subsidiary cannot be a hedged item in a fair
value hedge because consolidation recognizes the
parent's share of the subsidiary's accrued net
profit or loss, rather than fair value changes,
in net profit or loss. A hedge of a net
investment in a foreign subsidiary is different.
There is no double counting because it is a hedge
of the foreign currency exposure, not a fair
value hedge of the change in the value of the
investment.  151. This Standard does not specify a single
method for assessing hedge effectiveness.  152. In assessing the effectiveness of a hedge,
an enterprise will generally need to consider the
time value of money.
28FAS Effectiveness Testing  http//www.qrm.com/p
roducts/mb/Rmbupdate.htm
 Dollar Offset (DO) calculates the ratio of dollar
change in profit/loss for hedge and hedged item  Relative Dollar Offset (RDO) calculates the ratio
of dollar change in net position to the initial
MTM value of hedged item  Variability Reduction Measure (VarRM) calculates
the ratio of the squared dollar changes in net
position to the squared dollar changes in hedged
item  Ordinary Least Square (OLS) measures the linear
relationship between the dollar changes in hedged
item and hedge. OLS calculates the coefficient of
determination (R2) and the slope coefficient (ß)
for effectiveness measure and accounts for the
historical performance  Least Absolute Deviation (LAD) is similar to OLS,
but employs median regression analysis to
calculate R2 and ß.
29Regression Versus Offset Effectiveness Tests
30The Dictionary of Financial Risk Management
defines dynamic hedging as follows 
http//snipurl.com/DynamicHedging
 Dynamic Hedging A technique of portfolio
insurance or position risk management in which an
optionlike return pattern is created by
increasing or reducing the position in the
underlying (or forwards, futures or shortterm
options in the underlying) to simulate the Delta
change in value of an option position. For
example, a short stock futures index position may
be increased or decreased to create a synthetic
put on a portfolio, producing a portfolio
insurancetype return pattern. Dynamic hedging
relies on liquid and reasonably continuous
markets with low to moderate transaction costs.
See Continuous Markets, Delta Hedge, Delta/Gamma
Hedge, Portfolio Insurance.
31Dynamic HedgingParagraph 144 of IAS 39 Reads as
Follows
 144. There is normally a single fair value
measure for a hedging instrument in its entirety,
and the factors that cause changes in fair value
are codependent. Thus a hedging relationship is
designated by an enterprise for a hedging
instrument in its entirety. The only exceptions
permitted are (a) splitting the intrinsic value
and the time value of an option and designating
only the change in the intrinsic value of an
option as the hedging instrument, while the
remaining component of the option (its time
value) is excluded and (b) splitting the interest
element and the spot price on a forward. Those
exceptions recognize that the intrinsic value of
the option and the premium on the forward
generally can be measured separately. A dynamic
hedging strategy that assesses both the intrinsic
and the time value of an option can qualify for
hedge accounting.
32New Example
33Example 9, Para 162, FAS 133 Appendix BCash Flow
Hedge Using Intrinsic Value
 XYZ specified that hedge effectiveness will be
measured based on changes in intrinsic value  The American call option purchased at 1/1/X1 has
a fourmonth term  The call premium is 9.25, the strike rate is
125, and the option is currently atthemoney  See 133ex09a.xls at http//www.cs.trinity.edu/rj
ensen/  Also seehttp//www.trinity.edu/rjensen/caseans/In
trinsicValue.htm
34Example 9 from FAS 133 Paragraph 162With 100
Delta Effectiveness
 Forecasted Transaction Option
Option  Entry
Time Intrinsic  Date Value
Value Value  Jan. 01 125.00
9.25 Premium 0  0.00 Intrinsic Value
 9.25 Time Value

35Example 9 from FAS 133 Paragraph 162January 31
 Forecasted Transaction Option
Option  Entry
Time Intrinsic  Date Value
Value Value  Jan. 01 125.00
9.25 0 
Debit Credit Balance  Jan. 01 Call option 9.25
9.25  Cash
9.25 (9.25)  For cash flow hedges, adjust hedging derivative
to fair value and offset to OCI to the extent of
hedge effectiveness.
36Example 9 from FAS 133 Paragraph 162With 100
Delta Effectiveness
 Forecasted Transaction Option
Option Total  Entry
Time Intrinsic Option  Date Value
Value Value Value  Jan. 01 125.00
9.25 Premium 0 9.25  Jan. 31 127.25
7.50 2.25 9.75  2.25 Change in Hedged
Intrinsic Value  2.25 Change in Hedge Contract
Intrinsic Value Delta 1.00 or
100 based on intrinsic value  Delta 0.44 44
(9.759.25)/ (127.25125.00) 
37Example 9 from FAS 133 Paragraph 162January 31
 Forecasted Transaction Option
Option  Entry
Time Intrinsic  Date Value
Value Value  Jan. 01 125.00
9.25 0  Jan. 31 127.25
7.50 2.25 
Debit Credit Balance  Jan. 31 Call option 0.50
9.75  PL 1.75
1.75  OCI
2.25 (2.25)  For cash flow hedges, adjust hedging derivative
to fair value and offset to OCI to the extent of
hedge effectiveness.
38Example 9 from FAS 133 Paragraph 162February 28
 Forecasted Transaction Option
Option  Entry
Time Intrinsic  Date Value
Value Value  Jan. 31 127.25
7.50 2.25  Feb. 28 125.50
5.50 0.50 
Debit Credit Balance  Feb. 28 OCI 1.75
(0.50)  PL 2.00
3.75
Call option 3.75 6.00  For cash flow hedges, adjust hedging derivative
to fair value and offset to OCI to the extent of
hedge effectiveness.
39Example 9 from FAS 133 Paragraph 162March 31
 Forecasted Transaction Option
Option Total  Entry
Time Intrinsic Option  Date Value
Value Value Value
 Feb. 28 125.50
5.50 0.50 6.00  Mar. 31 124.25
3.00 0.00 3.00 
Debit Credit Balance  Mar. 31 OCI 0.50
0 PL
2.50 6.25
Call option 3.00
3.00  For cash flow hedges, adjust hedging derivative
to fair value and offset to OCI to the extent of
hedge effectiveness.
40Example 9 from FAS 133 Paragraph 162April 30
 Forecasted Transaction Option
Option Total  Entry
Time Intrinsic Option  Date Value
Value Value Value  Jan. 01 125.00
9.25 0.00 9.25  Mar. 31 124.25
3.00 0.00 3.00  Apr. 30 130.75
0.00 5.75 5.75 
Debit Credit Balance  Apr. 30 Call option 2.75
5.75 PL
3.00 9.25
OCI 5.75
5.75
41Example 9 from FAS 133 Paragraph 162With No
Basis Adjustment Under FAS 133

Debit Credit Balance  Apr. 30 Cash 5.75
3.50  Call option
5.75 0  Apr. 30 OCI No basis adjustment yet
PL No basis
adjustment yet  Apr. 30 Inventory 130.75
130.75  Cash
130.75 134.25 Cash 9.25
Premium 5.75 Call Option  130.75 134.25
42Example 9 from FAS 133 Paragraph 162With No
Basis Adjustment Under FAS 133

Debit Credit Balance  May 14 Cash 234.25
100.00  PL (or Sales)
234.25 225.00  May 14 PL (or CGS) 130.75
 94.25  Inventory
130.75 0  May 14 OCI 5.75
0  PL
5.75 100.00

43Example 9 from FAS 133 Paragraph 162With Basis
Adjustment Under IAS 39

Debit Credit  Apr. 30 Cash 5.75
Call option
5.75  Apr. 30 OCI 5.75
PL
5.75  Apr. 30 Inventory 130.75
Cash
130.75
44FUTURES /FORWARDS vs. OPTIONS
Futures / Forwards
Long Options
Unlimited risk/reward Limited risk/unlimited
reward No initial payment Initial payment
of premium Offsets risk and opportunity
Offsets risk/allows opportunity
45FUTURES vs. OPTIONS
Long Calls
Futures
Long Puts
Long
Bullish
Bearish
Short
Bearish
Bullish
Speculators
unlimited gain
unlimited gain
unlimited gain
limited risk
limited risk
unlimited risk
Lock in a price
Protect against
Protect against
rising price
falling price
Hedgers
Long
Buy price
Short Sell price
(for a premium)
(for a premium)
46OPTION VALUATION PRACTICES
 Actively traded, liquid contracts
 Use market data
 Where no market is available
 Requires markingtomodel
 Valuations will differ depending on the
particular model used, and the inputs to the
model  Market values should reflect present values of
expected future cash flows
47Why Discounted Cash FlowDoes Not Work Well for
Valuing Options
American
Can exercise anytime up to,
and including expiration date
European
Can exercise only on
expiration date, but may be able to sell the
option at current value
Risk
Risk varies over time making DCF valuation
ineffective
48GENERAL FEATURES OF OPTIONS ON FUTURES
Option prices move in variable proportion to
futures prices
Deep Inthemoney . . . .
High proportion
(almost onetoone) . . . .
Low proportion
Deep Outofthemoney
(almost zerotoone)
49GENERAL FEATURES OFOPTIONS ON FUTURES
 Deltas increase as options move (deeper)
inthemoney  Deltas are bounded between a minimum of zero and
a maximum absolute value of one  Time value is greatest for atthemoney options
50MEAN AND STANDARD DEVIATION
3 S.D.
2 S.D.
1 S.D.
Mean
51STANDARD DEVIATION
 1 standard deviation is the range associated with
a probability of 68.3  2 standard deviations is the range associated
with a probability of 95.4  3 standard deviations is the range associated
with a probability of 99.7
52NORMAL DISTRIBUTIONS
Frequency
High volatility
Low volatility
Returns
53STANDARD DEVIATIONAn Example
If the standard deviation is 10, that means...
Expected Price Change within 10 (1s.d.) within
20 (2s.d.) within 30 (3s.d.)
Probability 68.3 95.4 99.7
54CALCULATING HISTORICAL VOLATILITY
?? ?
T
VOL SD
Where
VOL
Annualized volatility
SD
Standard deviation of periodic price
changes (closing prices)
T
Number of trading periods per year
55VOLATILITY EXAMPLE
24 Annual Volatility
Daily SD (24 ? ?254) ? (24 ? 16) ? 1.5
68.3 probability that overnight change ? /
1.5 95.4 probability that overnight change ?
/ 3.0 99.7 probability that overnight change
? / 4.5
56IMPLIED VOLATILITIES
 Derived from current options prices
 Reflect probability distributions of forthcoming
price changes (i.e., the annualized standard
deviations)  Typically differ (significantly) from historical
volatilities  Generally differ across strike prices and
maturities
57OPTION PRICE DETERMINANTS
Premium f (IV, time, vol , r)
e
 Intrinsic value (IV)
 Time to expiration (time)
 Expected volatility (vol )
 Interest rates (r)
e
The implied volatility of a similar option is
the best input for expected volatility
58SWAPS vs. CAPS/FLOORS
Effective
Effective
Rate
Rate
Floor
Cap
Swap
Swap
Spot
Spot
Rate
Rate
R
R
(R  P
R
)
(R P
R
)
Floor
Swap
Cap
Swap
59BUILDING CAPS
 A cap is a series of individual options
(caplets), each relating to a specific
ratesetting date  The price of a cap is the sum of caplet prices
 Option horizons (times to expiration) increase
for successive ratesetting dates  All else equal, longerdated caplets are more
expensive than shorter dated caplets  Normal yield curves (i.e., expectations of rising
interest rates) inflate longer dated caplets, and
vice versa
60FORWARD RATES
10.00
7 Strike Yield
8.00
6.00
4.00
2.00
0.00
4
8
12
16
20
24
28
32
36
40
Quarters
61INTEREST RATE CAPS
Cap Levels
8
9
10
Premiums
2Year
3Year
4Year
62TWO YEAR COLLARBuy Caps at 8 or 9 Sell Floor
at 7.00
Collar Levels
9 / 7
8 / 7
Cap Premium
1.88
1.06
Floor Premium
0.58
0.58
Net Cost
1.30
0.48
63TWO YEAR CORRIDORBuy Caps at 8 or 9 Sell caps
at 10.00
Corridor Levels
8 / 10
9 / 10
Long Cap Premium
1.88
1.06
Short Cap Premium
0.62
0.62
Net Cost
1.26
0.44
64QUASIINSURANCEExamples
Corridor Fixes outcomes within a range of prices
Collar Constrains outcomes at price extremes
Hedged
Hedged
Spot
Spot
S
S
S
S
1
1
2
2
65New Example
66CASE 7  Cash Flow Hedge of Forecasted Treasury
Note Purchase
 On 1/1/X1, XYZ forecasts a 12/31/X1 purchase of
100 million 5year 6 Treasury notes to be
classified AFS  At 1/1/X1 the 1year forward rate for 5year
Treasury notes is 6  XYZ wants to lock in at least the 6 yield for
the 100 million Treasury note purchase  XYZs hedge strategy is to purchase a call option
on 100 million of the 5year Treasury notes that
have a 6 1year forward rate
67CASE 7  Cash Flow Hedge of ForecastedTreasury
Note Purchase
 XYZ specified that hedge effectiveness will be
measured based on the total price change of the
Treasury notes and the intrinsic value of the
option (zero at 1/1/X1)  The American call option purchased at 1/1/X1 has
a 1year term  The call premium is 1.4 million, the strike rate
is 6, and the option is currently atthemoney
68CASE 7  Cash Flow Hedge of ForecastedTreasury
Note Purchase
 On 1/1/X1, the following activity is recorded
 Call option asset 1,400,000
 Cash 1,400,000
 To record the option purchase
69CASE 7  Cash Flow Hedge of ForecastedTreasury
Note Purchase
 At 6/30/X1, the 12/31X1 forward 5year Treasury
rate has declined 100 basis points from 6 to 5
and the market price is 104.376. The following
entry is recorded to reflect the increase in the
call options intrinsic value.  Call option asset 4,376,000
 OCI 4,376,000
 To record the call options intrinsic value
(assuming a price of 104.376, calculated as
500,000 annuity received for 10 semiannual
periods discounted at  5 4,376,000).
70CASE 7  Cash Flow Hedge of ForecastedTreasury
Note Purchase
 (continued)
 At 6/30/X1, XYZ also determines that the call
options time value has decreased  Earnings 800,000
 Call option asset 800,000
 To record call options time value decrease
71CASE 7  Cash Flow Hedge of ForecastedTreasury
Note Purchase
 At 12/31/X1, XYZ exercises the option and takes
delivery of the Treasury notes  Earnings 600,000
 Call option asset
600,000  To write off option time value balance
 Treasury notes 100,000,000
 Cash 100,000,000
 Treasury notes (premium) 4,376,000
 Call option asset 4,376,000
 To record exercise of option
72CASE 7  Cash Flow Hedge of ForecastedTreasury
Note Purchase
 The 12/31/X1 OCI balance of 4,376,000 is
reclassified into earnings over the life of the
bond. The interest method is used to calculate
the periodic amount reclassified into earnings.  The 4,376,000 Treasury note premium is amortized
over the life of the bond and offsets the above
OCI impact.  On a cash flow and earnings basis, XYZ succeeded
in locking in a minimum 6 return on the Treasury
notes as if these were purchased at par.
73CASE 7  Cash Flow Hedge of ForecastedTreasury
Note Purchase
 XYZ demonstrates that the hedge was effective as
follows  Price of a 6 bond purchased in a
 5 rate environment 104,376,000
 Less call option proceeds (4,376,000)
 Net price 100,000,000
74CASE 7  Cash Flow Hedge of ForecastedTreasury
Note Purchase
 If XYZ sold the 100 million bond on 6/30/X2, the
remaining OCI balance is reclassified into
earnings because the hedged item no longer
affects earnings.
75New Example
76CASE 8 Fair Value Hedge of AFS Security
 XYZ owns 1,000 shares of ABC worth 100 each
(100,000)  XYZ wants to hedge downside price risk
 On 1/1/X1, XYZ purchases an atthemoney put
option on 1,000 ABC shares expiring in 6 months
exercise price is 100 option premium is 15,000  Effectiveness is measured by comparing decreases
in fair value of investment with intrinsic value
of option
77CASE 8Fair Value Hedge of AFS Security
Value at Value at Gain/ 1/1/X1
3/31/X1 (Loss) ABC Shares 100,000
98,000 ( 2,000) Put Option Intrinsic value
0 2,000 2,000 Time value
15,000 8,000 (7,000) Total
15,000 10,000 ( 5,000)
Note The time value of the option includes the
volatility value and the effects of discounting.
78CASE 8Fair Value Hedge of AFS Security
 Journal entry at 1/1/X1
 Option Contract 15,000
 Cash 15,000
 To record payment of option premium
 No journal entry for hedged item
79CASE 8Fair Value Hedge of AFS Security
 Journal entries at 3/31/X1
 Earnings 2,000
 Investment in ABC 2,000
 To record loss on investment in ABC
 Earnings (time value) 7,000
 Option contract 5,000
 Earnings (intrinsic value) 2,000
 To record activity up to 3/31/X1