Question : Question
E9.9 Call Options Hedging Foreign Currency
E9.9 Call Options Hedging Foreign Currency Debt. Taking advantage of lower interest rates in the
United Kingdom, Carlton Inc., a U.S. firm, borrowed £2,000,000 on July 1, 2016, to be repaid in one year.
When the transaction occurred, the exchange rate was $1.50/£. To hedge against possible appreciation
of the British pound, Carlton paid a premium of $0.014/£ for July 2017 call options on £2,000,000, with
a strike price of $1.49/£. On December 31, 2016, when Carlton's books are closed, the exchange rate is
$1.55/£, and the calls are selling for $0.069/£. On June 30, 2017, Carlton sells the calls for $0.12/£. The
exchange rate at that time is $1.61/£.
a. Does hedge accounting apply in this situation? Explain.
b. Prepare Carlton's journal entries made on July 1, 2016, December 31, 2016, and June 30, 2017, to recognize the calls' value changes and the exchange rate adjustments on the debt. Ignore interest on and repayment of the debt.