Question

Mini Case for Assignment 1

Out Of This Galaxy (OTG) is an astro-science supplier located in Hamilton, Ontario. It

supplies planetariums with materials to put on their star shows. All of OTG’s

previous business has been to Canadian customers, but OTG has expanded its

customer base and has just made its first international sale. The selling price of the

goods was FC200,000. OTG’s CFO entered the company into a forward contract to

help with risk management, but has since left the company. The company’s CEO is

not sure what a forward contract is, and the company’s small accounting

department has never heard of a forward contract either. OTG’s year end is

December 31st.

You, CPA, have been asked for the following:

1. Advise OTG on forward contracts and discuss any relevant information

and/or implications, given that OTG has already entered into the forward

contract.

2. Prepare the journal entries required, assuming that this contract will be

designated as a cash flow hedge.

* Note that FC = Foreign Currency

The information that you have related to the Forward Contract are as following:

Date of Sale: October 15, Y1

Date of Delivery of goods: January 30, Y2

Forward Contract entered into: October 15, Y1. Spot rate FC1 = $1.20; forward rate

FC1 = $1.22

December 31, Y1 spot rate FC1 = $1.222; 30-day forward rate FC1= $1.231

January 30, Y2 spot rate FC1 = $1.24.

Please use the case format

Answer 1

A forward contract is a customized contract between two parties to buy or sell an asset at a specified price on a future date. A forward contract can be used for hedging or speculation, although its non-standardized nature makes it particularly apt for hedging. Forward contracts do not trade on a centralized exchange and are therefore regarded as over-the-counter (OTC) instruments. While their OTC nature makes it easier to customize terms, the lack of a centralized clearinghouse also gives rise to a higher degree of default risk. As a result, forward contracts are not as easily available to the retail investor as futures contracts.

Risks with Forward Contracts

The market for forward contracts is huge since many of the world’s biggest corporations use it to hedge currency and interest rate risks. However, since the details of forward contracts are restricted to the buyer and seller – and are not known to the general public – the size of this market is difficult to estimate.

The large size and unregulated nature of the forward contracts market mean that it may be susceptible to a cascading series of defaults in the worst-case scenario. While banks and financial corporations mitigate this risk by being very careful in their choice of counterparty, the possibility of large-scale default does exist.

Another risk that arises from the non-standard nature of forward contracts is that they are only settled on the settlement date and are not marked-to-market.utures. What if the forward rate specified in the contract diverges widely from the spot rate at the time of settlement?

In this case, the financial institution that originated the forward contract is exposed to a greater degree of risk in the event of default or non-settlement by the client than if the contract were marked-to-market regularly.

Conclusion:

• A forward contract is a customized contract between two parties to buy or sell an asset at a specified price on a future date.
• Forward contracts can be customized to a commodity, amount and delivery date.
• Forward contracts do not trade on a centralized exchange and are considered over-the-counter instruments.

Please see attached file for journal entry.