Question

In January 20X5, Anne entered into a five-year fixed-price contract for champagne to protect WP against market fluctuations. During each of the first three years of the contract, Anne's decision appeared to be a good one, as the price of champagne continued to go up. At December 31, 20X7, the market price of champagne dropped significantly. Anne heard that the price per case is expected to remain at this level or drop even more over the next two years. On December 31, Anne triggered the cancellation clause that allows WP to get out of the contract for $60,000. The payment was made and expensed on January 2, 20X8.

Answer 1

Anne entered into a fixed-price contract to hedge against market volatility, with conditions that reflected understanding of real vs. nominal price. When market conditions changed, she used a cancellation clause to exit the contract, indicating a strategic financial decision to minimize losses. This example emphasizes the significance of inflation adjustments in long-term contracts.

Step-by-step explanation:

The scenario involves Anne entering into a fixed-price contract for champagne as a strategic move to protect against market fluctuations. Such contracts typically have provisions where prices are adjusted according to inflation, aligning with the concept of a real price as opposed to a nominal price. This means the real financial commitment reflects the true cost over time, considering how inflation impacts buying power.

In Anne’s case, she benefited from the fixed price in the early years when the market price for champagne rose. However, the subsequent market price drop meant that the contract became disadvantageous. Therefore, she utilized a cancellation clause, incurring a cost of $60,000, to exit the deal and potentially avoid greater losses had she continued with the overpriced contract terms.

The concept of real price vs. nominal price is critical here, as it demonstrates the importance of inflation adjustments in long-term contracts for preserving the value of money over time.