SMch12Beams

Chapter 12

Derivatives and Foreign Currency: Concepts and Common Transactions

Answers to Questions

1 Derivative is the name given to a broad range of financial securities. Their common characteristic is that the derivative contract’s value to the investor is directly related to fluctuations in price, rate, or some other variable that underlies it. Interest rate, foreign currency exchange rate, commodity prices and stock prices are common types of prices and rate risks that companies hedge.

2 A Forward is negotiated directly with a counterparty, while a future is a standard contract traded on an exchange. The exchange traded instrument has less risk of non-performance, and is commonly cheaper to transact. But standard contracts might not fit all companies’ needs. The forward carries the risk of counterparty default, but each contract can be tailored to exact needs.

3 An option gives the holder the right to buy or sell the underlying at a set price. The writer of an option has the obligation to either buy or sell. Options are often traded on exchanges and have low transaction costs. Because an option is an agreement on a single transaction, they are not helpful in managing the risk of a stream of future transactions. A swap is an agreement to exchange a series of future cash flows. These are often negotiated, but there are some standardized exchange-traded swaps.

4 Net settlement means the instrument can be settled in cash for the net value. The parties in a net settlement do not have to buy or sell physical products and then realize the cash flows. Only one payment needs to be made, either from the holder or the writer of the instrument.

5 A transaction is measured in a particular currency if its magnitude is expressed in that currency. Assets and liabilities are denominated in a currency if their amounts are fixed in terms of that currency.

6 Direct quotation: 1.20/1 = $1.20Indirect quotation: 1/1.20 = .83 euros per dollar

7 Official or fixed rates are set by a government and do not change as a result of changes in world currency markets. Free or floating exchange rates are those that reflect fluctuating market prices for currency based on supply and demand factors in world currency markets. The United States changed from fixed to floating (free) exchange rates in 1971. But the U.S. dollar is sometimes described as a “filthy float” because the United States has frequently engaged in currency transactions to support or weaken the dollar against other currencies. Such action is taken for economic reasons, such as to make U.S. goods more competitive in world markets. Both Japan and Germany have engaged in currency transactions in an attempt to support the U.S. dollar. In February 1987, the United States and six other industrial nations (the Group of 7 or G-7) entered the Louvre accord to cooperate on economic and monetary policies in support of agreed upon exchange rate levels.

8 Spot rates are the exchange rates for immediate delivery of currencies exchanged. The current rate for foreign currency transactions is the spot rate in effect for immediate settlement of the amounts denominated in foreign currency at the balance sheet date. Historical rates are the rates that were in effect on the date that a particular event or transaction occurred. Spot rates could be fixed rates if the currency was a fixed rate currency as determined by the government issuing the currency.

9 The transaction is a foreign transaction because it involves import activities, but it is not a foreign currency transaction for the U.S. firm because it is denominated in local currency. It is a foreign currency transaction for the Japanese company.

12-2 Derivatives and Foreign Currency: Concepts and Common Transactions

10 At the transaction date, assets and liabilities denominated in foreign currency are translated into dollars by use of the exchange rate in effect at that date, and they are recorded at that amount.

At the balance sheet date, cash and amounts owed by or to the enterprise that are denominated in foreign currency are adjusted to reflect the current rate. Assets carried at market whose current market price is stated in a foreign currency are adjusted to the equivalent dollar market price at the balance sheet date.

11 Exchange gains and losses occur because of changes in the exchange rates between the transaction date and the date of settlement. Both exchange gains and exchange losses can occur in either foreign import activities or foreign export activities. The statement is erroneous.

12 Exchange gains and losses on foreign currency transactions are reflected in income in the period in which the exchange rate changes except for hedges of an identifiable foreign currency commitment where deferral is possible if certain requirements are met. Also hedges of a net investment in a foreign entity are treated as equity adjustments from translation. Intercompany foreign currency transactions of a long-term nature are also treated as equity adjustments.

13 There will be a $20 exchange loss in the period of purchase and a $10 exchange gain in the period of settlement:

Billing datePurchases $1,450

Accounts payable (fc) $1,450Year-end adjustment

Exchange loss $ 20Accounts payable (fc) $ 20

Settlement dateAccounts payable (fc) $1,470

Cash $1,460Exchange gain 10

Pearson Education, Inc. publishing as Prentice Hall

Chapter 12 12-3

SOLUTIONS TO EXERCISES

Solution E12-1

1 b2 c3 d4 a

Solution E12-2

1 c2 a3 d4 b

Solution E12-3

1 b2 d3 d

Solution E12-4

1 The dollar has weakened against the yen because it now costs more dollars to buy one yen.

2 10,000,000 yen $.0075 = $75,000

3 Accounts payable $75,000Exchange loss 1,000

Cash $76,000

4 Zimmer would have entered a contract to purchase yen for future receipt. This would assure that Zimmer had the yen available at that date to pay their obligation, and would have ‘locked in’ the amount of US dollars needed to satisfy that obligation.

Solution E12-5

December 16, 2011Inventory $36,000

Accounts payable (euros) $36,000To record purchase of merchandise from Wing Corporation for 30,000 euros at $1.20 spot rate.

December 31, 2011Exchange loss $ 1,500

Accounts payable (euros) $ 1,500To adjust accounts payable to Wing: ($1.25 - $1.20) 30,000 euros.

January 15, 2012Accounts payable (euros) $37,500



Exchange gain $ 300Cash 37,200

To record payment of 30,000 euros at $1.24 spot rate in settlement of account payable and to recognize gain.

Solution E12-6

Adjustment in value of account receivable for 2011:($.84 - $.80) 90,000 C$ = $3,600 exchange gain

Adjustment in value of account receivable at settlement in 2012:($.83 - $.84) 90,000 C$ = $900 exchange loss

Solution E12-7

May 1, 2011Accounts receivable (fc) $333,333

Sales $333,333To record sale of inventory items to Royal for 200,000 pounds: 200,000 pounds/.6000 pounds (indirect quotation).

May 30, 2011Cash (fc) $330,579Exchange loss 2,754

Accounts receivable (fc) $333,333To record receipt of 200,000 pounds from Royal in settlement of accounts receivable: 200,000 pounds/.6050 pounds.

Solution E12-8 [Based on AICPA]

1Receivable at 10/15/08 $420,000Euros received and sold for U.S. dollars on 11/16/08

415,000

Foreign exchange loss 2011 5,000

2 On December 31, 2011 Yumi Corp. adjusts its account payable denominated in euros from $12,000 (10,000*.$1.20) to $12,400 (10,000 $1.24) and recognizes a loss of $400 [10,000 LCU ($1.24 - $1.20)]

3December 31, 2011 note payable $240,000July 1, 2012 note payable 280,000 2012 exchange loss $(40,000)

4Note receivable December 31, 2011 $140,000Amount collected July 1, 2012 (840,000 LCU 8) 105,000 2012 exchange loss $ 35,000


Chapter 12 12-5

Solution E12-9

1 Exchange gain or loss in 2011: Gain or (Loss)Account receivable December 16 $103,500December 31 adjusted balance

150,000 C$ $0.68 102,000 $(1,500)Account payable December 2 $195,250December 31 adjusted balance

275,000 C$ $0.68 187,000 8,250 Net exchange gain for 2011 $ 6,750

2 Exchange gain or loss in 2012: Gain or (Loss)Account receivable adjusted 12/31 $102,000Account receivable 1/15/09

150,000 C$ x $0.675 101,250 $ (750)Account payable adjusted 12/31 $187,000Account payable 1/30/09

275,000 C$ x $0.685 188,375 (1,375 )Net exchange loss for 2012 $(2,125)

Solution E12-10

1 December 12, 2011Inventory $375,000

Accounts payable (yen) $375,000Purchase from Toko Company (50,000,000 yen $.00750).

December 15, 2011Accounts receivable (pounds) $ 66,000

Sales $ 66,000Sale to British Products Company (40,000 pounds $1.65).

2 December 31, 2011Exchange loss $ 5,000

Accounts payable (yen) $ 5,000To adjust accounts payable denominated in yen for exchange rate change: 50,000,000 yen ($.00760 - $.00750).

Exchange loss $ 2,000Accounts receivable (pounds) $ 2,000To adjust accounts receivable denominated in pounds for exchange rate change: 40,000 pounds ($1.65 - $1.60).

3 January 11, 2012Accounts payable (yen) $380,000Exchange loss 2,500

Cash $382,500To record payment to Toko Company (50,000,000 yen $.00765).

January 14, 2012Cash $ 65,200

Accounts receivable (pounds) $ 64,000Exchange gain 1,200To record receipt from British Products Company: 40,000 pounds $1.63.




Chapter 12 12-7

Solution E12-11Comment: The contract receivable and payable are both recorded instead of recording the contract net because Martin must deliver the euros to the exchange broker, net settlement is not allowed.

October 2, 2011Contract receivable $653,000

Contract payable (fc) $653,000To record contract to sell 1,000,000 euros to exchange broker in 180 days for the forward rate of $.6530.

December 31, 2011Contract payable (fc) $ 12,000

Exchange gain $ 12,000To adjust contract payable in euros to the 90-day forward rate of $.6410.

March 31, 2012Contract payable (fc) $641,000Exchange loss 14,000

Cash (fc) $655,000To record payment of 1,000,000 euros to exchange broker when spot rate is $.6550.

Cash $653,000Contract receivable $653,000

To record receipt of U.S. dollars from exchange broker in settlement of account.

SOLUTIONS TO PROBLEMS

Solution P12-1

TCO would receive $8,000 from XYZ = 100,000(2.48-2.40)

Solution P12-2

There is a typo in the problem, Sue's cost should be $5.90

The expected profit for Sue is 300,000 (6.20 - 5.90) = 90,000

Market Price per Bushel

Forward Price per Bushel

Unhedged Gain/(Loss)

Economic Gain/(Loss) on

Forward

Economic In-come with

Hedge

$6.40 $6.20 $150,000 $(60,000) $90,000

$6.30 $6.20 120,000 (30,000) 90,000

$6.20 $6.20 90,000 — 90,000

$6.10 $6.20 60,000 30,000 90,000



$6.00 $6.20 30,000 60,000 90,000

Solution P12-3

The expected profit for Sue is 300,000(6.20 - 5.90 - 0.05) = 75,000

Market Price per Bushel

Option Price per Bushel

Unhedged Gain/(Loss)

Economic Gain/(Loss) on

Option

Economic In-come (Loss) with Cost of

Option

$6.40 $6.20 $150,000 --- $135,000

$6.30 $6.20 120,000 --- 105,000

$6.20 $6.20 90,000 — 75,000

$6.10 $6.20 60,000 30,000 75,000

$6.00 $6.20 30,000 60,000 75,000

Solution P12-4

1, 2 Per Balance Exchange Gain Books Sheet or (Loss)

Accounts receivableU.S. dollars $28,500 $28,500Swedish Krona (20,000 $.66) 11,800 13,200 $1,400British pounds(25,000 $1.65) 41,000 41,250 250

$81,300 $82,950 1,650 Accounts payableU.S. dollars $ 6,850 $ 6,850Canadian dollars (10,000 $.70) 7,600 7,000 $ 600British pounds (15,000 $1.65) 24,450 24,750 (300 )

$38,900 $38,600 300 Net exchange gain $1,950

3 Collect receivables:

Cash $28,500Accounts receivable $28,500

To record collection of accounts receivable.


Chapter 12 12-9

Cash $13,400Accounts receivable (Krona) $13,200Exchange gain 200

To collect 20,000 Krona at $.67 spot rate.

Cash $40,750Exchange loss 500

Accounts receivable (pounds) $41,250To collect 25,000 pounds at $1.63 spot rate.

4 Settlement of accounts payable:

Accounts payable $ 6,850Cash $ 6,850

To record payment of accounts denominated in dollars.

Accounts payable (Canadian $) $ 7,000Exchange loss 100

Cash $ 7,100To record payment of account denominated in Canadian dollars at $.71 spot rate.

Accounts payable (pounds) $24,750Cash $24,300Exchange gain 450

To record payment of 15,000 pounds at $1.62 spot rate.

Solution P12-5

1, 2 Balance Exchange GainPer Books Sheet or (Loss)

Accounts receivableBritish pounds (100,000 1.660) $165,000 $166,000 $1,000Euros (250,000 $.670) 165,000 167,500 2,500Swedish krona (160,000 $.640) 105,600 102,400 (3,200)Japanese yen (2,000,000 $.0076) 15,000 15,200 200

$450,600 $451,100 500

Accounts payableCanadian dollars(150,000 $.69) $105,000 $103,500 $1,500Swedish krona (220,000 $.135) 28,600 29,700 (1,100)Japanese yen (4,500,000 $.0076) 33,300 34,200 (900 )

$166,900 $167,400 (500 )

Net exchange gain $ 0

3 The company would need to enter into a contract to deliver 250,000 euros (sell them) since it would be receiving euros and would need to convert them into US dollars.


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