Chapter Seven

Foreign Foreign Currency Currency

Transactions Transactions and Hedging and Hedging

Foreign Foreign Exchange RiskExchange Risk

McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Foreign Exchange Rates

An Exchange Rate is the cost of one currency in terms of another.

Rates published daily in the Wall Street Journal are as of 4:00pm Eastern time on the day prior to publication.

The published rates are wholesale rates that banks use with each other – retail rates to consumers are higher.

The difference between the rates at which a bank is willing to buy and sell currency is known as the “spread.”

Rates change constantly!!

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Foreign Exchange Rates

Spot Rate The exchange rate that is

available today.

Forward Rate The exchange rate that

can be locked in today for an expected future exchange transaction.

The actual spot rate at the future date may differ from today’s forward rate.

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This forward contract allows us to purchase 1,000,000 ¥ at a price

of $.0080 US in 30 days.

But if the spot rate is $.0069 US in 30

days, we still have to pay $.0080 US and we lose $1,100!!

Foreign Exchange - Forward Contracts

A forward contract requires the purchase (or sale) of currency units at a future date

at the contracted exchange rate.

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An alternative is an option contract to

purchase 1,000,000 ¥ at $.0080 US in 30 days. But it costs

$.00002 per ¥.

That way, if the spot rate is $.0069 in 30 days, we only lose the $20 cost of the

option contract!

Foreign Exchange – Option Contracts

An options contract gives the holder the option of buying (or selling) currency units at a future date at the contracted

“strike” price.

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Foreign Currency - Option Contracts

A “put” option allows for the sale of foreign currency by the option holder.

A “call” option allows for the purchase of foreign currency by the option holder.

Remember: An option gives the holder “the

right but not the obligation” to trade the foreign currency

in the future.

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Foreign Currency Transactions

A U.S. company buys or sells goods or services to a party in another country. This is often called foreign trade.

The transaction is often denominated in the currency of the foreign party.

How do we account for the changes in the

value of the foreign

currency?

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Foreign Currency Transactions

GAAP requires a two-transaction perspective.

(1)Account for the original sale in US Dollars.

(2)Account for gains/losses from exchange rate

fluctuations.

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Hedging Foreign Exchange Risk

Companies will seek to reduce the risks associated with foreign

currency fluctuations by hedging…

This means they will give up a portion of the potential gains to offset the

possible losses.

A company enters into a potential transaction whose exposure is the

opposite of the one that has the associated risk.

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Hedging Foreign Exchange Risk

Two foreign currency derivatives that are often used to hedge foreign currency transactionsForeign currency

forward contractsForeign currency

options

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Accounting for Derivatives

The fair value of the derivative is recorded at the same time as the

transaction to be hedged, based on:

1) The forward rate when the forward contract was entered into.

2) The current forward rate for a contract that matures on the same

date as the forward contract.3) A discount rate (the company’s

incremental borrowing rate).

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Accounting for Hedges

As the Fair Value of a forward contract changes, gains or losses are recorded.

The company hopes to recognize the gain or loss from the hedge in the same period

as the opposing gain or loss on the risk

being hedged

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Accounting for Hedges

There are two ways that a foreign currency hedge can be accounted for.

Cash Flow

Hedge

Fair Value Hedge

Gains/losses are recorded as

Comprehensive Income

Gains/losses are recorded on the Income

Statement

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Accounting for Hedges

Cash Flow

Hedge

Fair Value Hedge

A Cash Flow Hedge completely

offsets the variability of a

foreign currency receivable or

payable.

Any other hedging instrument is a Fair

Value Hedge.

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Option values

Derived from a function combining:The difference between current spot

rate and strike priceThe difference between foreign and

domestic interest ratesThe length of time to option

expirationThe potential volatility of

changes in the spot rate

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Using a Foreign Currency Option as a Hedge

Options are carried at fair value on the balance sheet.

Option fair values are determined by examining

the current quotes for similar options and

breaking the fair value into two components:

Intrinsic Value & Time Value

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The gain/loss on the hedge is

recognized currently in net

income, as is the gain/loss on the firm commitment attributable to the

hedged risk.

Hedge of a Foreign Currency Firm Commitment

Occurs when a company hedges a transaction that has yet to take place.

ExampleRuff Wood orders

1,000,000 board feet of lumber

from Brazil. Ruff Wood enters the

hedge contract on the same day as

the order is placed.

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Hedge of a Forecasted Foreign Currency Denominated Transaction

Cash flow hedge accounting may be used for foreign currency derivatives associated with a forecasted foreign currency transactionThe forecasted transaction must be

probable, highly effective, and the hedging relationship must be properly documented.

Gains and losses on the hedging instrument are recorded in Other Comprehensive Income until the date of the forecasted transaction.

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