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Assume that in March, a processor of cereals and other food forecasts a purchase of 300 tons of
soybean meal for June delivery. Concerned that prices may increase, the processor purchases three
at-the-money, June call options on March 10. On the Chicago Board of Trade (CBT), the options are
trading at $800 per option with a strike price of $165 per ton. Note that the option was trading at-the-
money, which means that the strike price ($165) and current spot price ($165) are equal and that the
option has no intrinsic value. The $800 paid for the option reflects time value. Each option is for a 100-
ton unit with delivery at a warehouse specified by the CBT and a settlement date of June 25.
Effectiveness of the hedge is measured by comparing rates for soybean meal. Therefore, the change
in time value of the option is excluded from the assessment of hedge effectiveness. In addition to the
information given above, the following data are relevant to the hedging strategy:
Cash Flow Hedge: Hedged Item – Variable Interest Notes Receivable; Hedging Instrument – Swap
Assume that on June 30, 20X1, an entity has lent $10,000,000 for 1.5 years with semi-annual interest
due based on a variable rate of LIBOR + 1% (100 basis points). On June 30, 20X1, concerned that
variable interest rates will decline, the entity enters into a swap to receive a fixed rate of 7% in return
for payment of a variable LIBOR + 1.25% (125 basis points) rate. The notional amount of the swap is
$10,000,000. At each semi-annual period, the swap is settled, and the variable rate is reset for the
following semi-annual interest payment.