chapter seven foreign currency transactions and hedging foreign exchange risk mcgraw-hill/irwin...
TRANSCRIPT
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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