On January 2, 2011, Reflow Corporation purchased a call option for $350 on Walter’s common shares. The call option gives Reflow the option to buy 1,000 shares of Walter at a strike price of $25 per share.
The market price of a Walter share was $25 on January 2, 2011 (the intrinsic value was therefore $0). On March 31, 2011, the market price for Walter stock was $38 per share, and the value of the option was $15,500.
Instructions
(a) Prepare the journal entry to record the purchase of the call option on January 2, 2011.
(b) Prepare the journal entry(ies) to recognize the change in the call option’s fair value as of March 31, 2011.
(c) What was the effect on net income of entering into the derivative transaction for the period January 2 to March 31, 2011?
(d) Based on the available facts, explain whether the company is using the option as a hedge or for speculative purposes.
(e) Explain which financial risks the transaction exposes the entity to.