Shandra Corporation (a U. S.-based company) expects to order goods from a foreign supplier at a price of 131,000 pounds, with delivery and payment to be made on April 20. On February 20, when the spot rate is $1.37 per pound, Shandra purchases a two-month call option on 131,000 pounds and designates this option as a cash flow hedge of a forecasted foreign currency transaction. The time value of the option is excluded in assessing hedge effectiveness; the change in time value is recognized in net income over the life of the option. The option has a strike price of $1.37 per pound and costs $1,310. The goods are received and paid for on April 20. Shandra sells the imported goods in the local market by May 31. The spot rate for pounds is $1.42 on April 20. What amount will Shandra Corporation report as foreign exchange gain or loss in net income for the quarter ended June 30

Shandra Corporation

The amount which Shandra Corporation will report as foreign exchange gain in net income for the quarter ended June 30 is:

$5,240

Explanation:

Price of goods = 131,000 pounds

Delivery and payment date = April 20

On February 20, the spot rate for call option on 131,000 pounds = $1.37

Cost of the option = $1,310

The spot rate on April 20 = $1.42

The foreign exchange gain or loss to be reported in net income for the quarter ended June 30 = $0.05 ($1.42 - $1.37

Total gain = ($0.05 * 131,000) - $1,310

= $6,550 - $1,310

= $5,240

b) With this call option, which gives Shandra the right to buy the underlying asset, Shandra hedges his contract to purchase goods from a foreign supplier, and therefore, profits when the spot rate increases from $1.37 on February 20 to $1.42 on April 20.  The profit made is reduced by the cost of the call option.

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