Option Contract

Option Contract Gives the holder the right, but not the obligation, tobuy share at a preset price for a specified period of time. Example: Dell enters into a contract with a broker for an

option (right) to purchase 10,000 shares of Google stocks at its current price of $110 per share.

The broker charges $3,000 for holding the contract open for two weeks at a set price.

Dell has received the right, but not the obligation to purchase this stock at $110 within the next two weeks.

Option Contract

 

Call option: Gives the holder the right, but not the obligation, to buy shares at a preset price (strike price or exercise price).

A holder can realize a gain from the increase in the value of the underlying share with the use of a Call Option.

Example: A company enters into a call option contract on January 2, 2007, with Baird investment Co., which gives it the option to purchase 1,000 shares of Laredo stock at $100 per share. On January 2nd, the Laredo shares are trading at $100 per share. The option expires on April 30, 2007. The company purchases the call option for $400.

If the price of Laredo stock increases above $100, the company

can exercise this option and purchase the shares for $100 per share.

If Laredo’s stock never increases above $100 per share, the call option is worthless.

Option Contract

 

Accounting entries:(1) To record purchase (option premium) of call option: Call Option 400 Cash 400

The option premium consists of two amounts: Intrinsic Value & Time value

*Option premium = Intrinsic value + Time value;

(a)Intrinsic value = Preset strike price - Market price On January 2, the intrinsic value is ZERO because

the market price equals the preset strike price.

(b)Time value is estimated using an option-pricing model. It reflects the possibility that the option has a fair value

greater than zero. WHY? Because, there is expectation that the price of Laredo shares will increase above the strike price during the option term. On January 2, the time value of the option is $400.

Option Contract

 

(2) FYE Adjustments: March 31, 2007:a. To record increase in intrinsic value of option:

On March 31, 2007, Laredo shares are trading at $120 per share.

Therefore, the Intrinsic Value of the Call Option is now:$20,000 = $120,000 – $100,000.

This gives the company an unrealized gain of: $20,000 = $20,000 - $0.

The company records the increase in intrinsic value as follows: Call Option 20,000 Unrealized Holding Gain or Loss—Income20,000

Option Contract

 

(b) To record decrease in time value of the option:

On March 31, 2007, a market appraisal indicates that the time value of the option is $100.

This gives the company an unrealized loss of $300:$300 = $400 - $100

The company records this change in time value as follows: Unrealized Holding Gain or Loss—Income 300 Call Option 300

Option Contract

 

(4) To record the settlement of the call option contract with Baird on April 1, 2007:

On April 1, 2007, the company exercises the call option (simultaneously buys and sells) and records the settlement of the call option with Baird as follows: Cash (120,000 – 100,000 = net cash) 20,000Loss on Settlement of Call Option 100

Call Option 20,100

Option Contract

Effects of the call option on net income: Date Transaction Income (Loss) Effect

March 31, 2007 Net increase in value of call option $19,700

April 1, 2007 Settle call option (100) Total net income $19,600