emba module 8

McGraw-Hill/IrwinInternational Business, 5/e

© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved.

EMBA Module 8

Foreign Currency Foreign Currency Transactions and Hedging Transactions and Hedging

Foreign Exchange RiskForeign Exchange Risk



Exchange Rate Mechanisms• Prior to 1973, currency

values were generally fixed. The US $ was based on the Gold Standard.

• Since 1973, exchange rates have been allowed to fluctuate.

• Several valuation models exist.

• Prior to 1973, currency values were generally fixed. The US $ was based on the Gold Standard.

• Since 1973, exchange rates have been allowed to fluctuate.

• Several valuation models exist.

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Different Currency Mechanisms

• Independent Float (the currency is allowed to fluctuate according to market forces)

• Pegged to another currency (the currency’s value is fixed in terms of a particular foreign currency, and the central bank will intervene to maintain the fixed value)

• European Monetary System – A common currency (the euro) is used in different countries. Its value floats against other world currencies.

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Foreign Exchange Markets• Countries use currencies for

internal economic transactions.• To make transactions in

another country, units of that country’s currency may need to be acquired.

• The price at which a currency can be acquired is known as the “exchange rate.”

• Countries use currencies for internal economic transactions.

• To make transactions in another country, units of that country’s currency may need to be acquired.

• The price at which a currency can be acquired is known as the “exchange rate.”

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Foreign Exchange Rates• Exchange rates are

published daily in the Wall Street Journal.– These are “end-of-day”

rates, as of 4:00pm Eastern time on the day prior to publication

• Remember – Rates change constantly

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

• Exchange rates are published daily in the Wall Street Journal.– These are “end-of-day”

rates, as of 4:00pm Eastern time on the day prior to publication

• Remember – Rates change constantly

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

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Foreign Exchange RatesAs the relative strength of a country’s economy

changes . . .

. . . the exchange rate of the local currency relative to other currencies also

fluctuates.

?¥ = $?

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Foreign Exchange RatesSpot 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.

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.

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 Options Contracts

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

An options contract gives the holder the option of buying (or selling) the 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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Insuring Against Foreign Exchange Risk

• Attempt to reduce the risk of adverse consequences on the firm due to unpredicted changes in future exchange rates

Hedging

when a firm insures itself against foreign exchange risk

Spot Exchange Rate Exchange rate of one currency into another

currency on a particular day

• Spot exchange rates are reported on a real-time basis– on a minute-by-minute basis– determined by the interaction between the demand and supply

of that currency relative to the demand and supply of other currencies

• Quoted as the– amount of foreign currency one U.S. dollar will buy– value of U.S. dollar for a one unit of foreign currency

Forward Exchange

Two parties agree to exchange currency and execute the deal at some specific date in the future

• Used by firms to insure or hedge against foreign exchange risk that can make a transaction unprofitable

• Exchange rates governing such future transactions are referred to forward exchange rates

• Forward exchange rates can be quoted for 30 days, 60 days, 90 days, 180 days or longer into the future

Forward Exchange Rates

Selling at a Premium

Expectation that the dollar will appreciate against the yen over the next 30 days

– Spot Rate: $1 = Y120– 30 days Forward: $1 = Y130

Forward Exchange Rates

Selling at a Discount

Expectation that the dollar will depreciate against the yen over the next 30 days

– Spot Rate: $1 = Y120– 30 days Forward: $1 = Y110

Reducing Risk

Forward Exchange

When two parties agree to exchange currency and execute the deal at some specific future date

• Insures against foreign exchange risk for a limited period

• US firm imports laptops (at the price of Y200,000) from a Japanese supplier and must pay the supplier in 30 days after arrival in Yen

• Current dollar/yen spot exchange rate is $1 = Y120• Importer’s cost is $1,667 (200,000/120)• Importer can sell the laptop at $2,000 at a gross profit of $333 (2,000-1,667)

• Importer does not have the funds to pay the supplier until laptops are sold• To hedge against the risk of exchange rate movements between the $ and Yen,

the importer can engage in a forward exchange

• Assume the dollar is selling at a 30-day discount at $1 = Y110• Importer is guaranteed to not pay more than $1,818 (200,000/110)• Importer guaranteed $182 gross profit and insures against a loss

• If the dollar is selling at a 30-day premium at $1 =Y130• Importer guaranteed to not pay more than $1,538 (200,000/130)• Importer guaranteed $462 gross profit and insures against a loss

Reducing RiskCurrency Swap

Simultaneous purchase and sale of a given amount of foreign exchange for two different value dates

• Insures against foreign exchange risk for a limited period

• Swaps are transacted between: – international firms and their banks– between banks– between governments

Today Apple needs to pay $1 M account payable to Japanese supplier

90 Days Apple collects Y120 M account receivable from Japanese customer

Spot Rate Today $1 = Y120

90 Day Forward Rate $1 = Y110

Swap• Apple sells $1 M to its bank in return for Y120 M and can pay its accounts payable

today

• At the same time, Apple enters into a 90-day forward exchange deal with its bank for converting Y120 M into US dollars

• Thus, in 90 days, Apple will receive $1.09 M (Y120/110 = 1.09)

• Since the Yen is selling at 90-day premium, Apple receives more dollars than it started with….but the opposite could also occur….but Apple knows today!



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.

The major accounting issue:

How do we account for the changes in

the value of the foreign currency?

The major accounting issue:

How do we account for the changes in

the value of the foreign currency?

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Foreign Currency Transactions

FASB No. 52Requires a two-transaction

perspective.

(1) Account for the original sale in US $

(2) Account for gains/losses from exchange rate

fluctuations.

FASB No. 52Requires a two-transaction

perspective.

(1) Account for the original sale in US $

(2) Account for gains/losses from exchange rate

fluctuations.

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?

Foreign Currency Transactions

. . . but the cash . . . but the cash flow is at a later flow is at a later

date . . .date . . .. . . fluctuating . . . fluctuating exchange rates exchange rates

can result in can result in exchange rate exchange rate

gains or losses.gains or losses.

When a When a transaction transaction

occurs on one occurs on one date (for example date (for example a credit sale) . . .a credit sale) . . .

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?

Foreign Currency TransactionsWhen the rate is expressed as the US $ equivalent

of 1 unit of foreign

currency, the rate is called a

“DIRECT QUOTE”

When the rate is expressed as the US $ equivalent

of 1 unit of foreign


“DIRECT QUOTE”

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Foreign Currency TransactionsWhen the rate is expressed as the

US $ equivalent of 1 unit of foreign


“DIRECT QUOTE”

When the rate is expressed as the

US $ equivalent of 1 unit of foreign


“DIRECT QUOTE”

When the rate is expressed as the number of foreign currency units that $1 will buy, the rate

is called an“INDIRECT QUOTE”

When the rate is expressed as the number of foreign currency units that $1 will buy, the rate

is called an“INDIRECT QUOTE”

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Foreign Exchange Transaction Example

On 12/1/08, Nuuk sells inventory to Coventry Corp. on credit. Coventry will pay Nuuk 10,000 British pounds

in 90 days.The current exchange rate is $1 = .6425 £.

Prepare Nuuk’s journal entry.

On 12/1/08, Nuuk sells inventory to Coventry Corp. on credit. Coventry will pay Nuuk 10,000 British pounds

in 90 days.The current exchange rate is $1 = .6425 £.

Prepare Nuuk’s journal entry.

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Foreign Exchange Transaction Example

On 12/31/08, the exchange rate is $1 = .6400 £.At the balance sheet date we have to “re-measure”, or

adjust, the original A/R to the current exchange rate.

On 12/31/08, the exchange rate is $1 = .6400 £.At the balance sheet date we have to “re-measure”, or

adjust, the original A/R to the current exchange rate.

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Foreign Exchange Transaction ExampleOn 3/1/09, Coventry Corp. pays Nuuk the 10,000 £ for

the 12/1/08 sale.The exchange rate on 3/1/09, was $1 = .6500 £.

On 3/1/09, we have to do TWO things. First, we must “re-measure” the A/R.

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Foreign Exchange Transaction ExampleOn 3/1/09, Coventry Corp. pays Nuuk the 10,000 £ for

the 12/1/08 sale.The exchange rate on 3/1/09, was $1 = .6500 £.

On 3/1/09, we have to do TWO things. Second, we must record receipt of the £.

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Hedging Foreign Exchange Risk

• Companies will seek to reduce the risks associated with foreign currency fluctuations by “hedging” their exposure

• This means surrendering a portion of potential gains to offset possible losses by entering into a potential transaction whose exposure is the opposite of that for the existing transaction.

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Hedging Foreign Exchange RiskTo control for the

risk of exchange rate fluctuation, a

forward contract for currency can be

purchased.

Hedging effectively reduces

the uncertainty associated with

fluctuating exchange rates.

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Hedging Foreign Exchange Risk• To hedge a foreign

currency transaction, companies may use foreign currency derivatives

• Two common tools:– Foreign currency

forward contracts– Foreign currency

options

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Accounting for Derivatives

SFAS 133 provides guidance for hedges of four types of foreign exchange risk.

SFAS 133 provides guidance for hedges of four types of foreign exchange risk.

Recognized foreign currency

denominated assets & liabilities.

Recognized foreign currency

denominated assets & liabilities.

Forecasted foreign currency

denominated transactions.

Forecasted foreign currency

denominated transactions.

Unrecognized foreign currency

firm commitments.

Unrecognized foreign currency

firm commitments.

Net investments in foreign

operations

Net investments in foreign

operations

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Accounting for Derivatives• Often a transaction involving a credit

sale/purchase is denominated in a foreign currency.

• On the transaction date, the foreign currency receivable/payable is recorded.

• If a forward contract is entered into to hedge the transaction, SFAS No. 133 requires the forward contract be carried at FAIR VALUE.

• Often a transaction involving a credit sale/purchase is denominated in a foreign currency.

• On the transaction date, the foreign currency receivable/payable is recorded.

• If a forward contract is entered into to hedge the transaction, SFAS No. 133 requires the forward contract be carried at FAIR VALUE.

?

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Determining the Value of DerivativesTo determine the value of foreign currency derivatives, the company needs 3 basic

pieces of information:

(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.

To determine the value of foreign currency derivatives, the company needs 3 basic

pieces of information:

(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.

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Accounting for Hedges

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

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

On 12/31/08, Chan has a forward contract to deliver

500,000¥ to Inuwashi Company on 1/31/09 at

120¥ = $1. The available 31-day forward rate on

12/31/08 is 122.50¥ = $1. Chan uses a discount rate

of 6%. What is the value of the forward contract on

12/31/08?

On 12/31/08, Chan has a forward contract to deliver

500,000¥ to Inuwashi Company on 1/31/09 at

120¥ = $1. The available 31-day forward rate on

12/31/08 is 122.50¥ = $1. Chan uses a discount rate

of 6%. What is the value of the forward contract on

12/31/08?

?

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Accounting for Hedges

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

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

Cash Flow

Hedge

Cash Flow

Hedge

Fair Value Hedge

Fair Value Hedge

Gains/losses are recorded as

Comprehensive Income

Gains/losses are recorded on the Income

Statement

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Cash Flow Hedge - Date of Transaction Example

On 4/1/08, Madh, Inc., a U.S. maker of auto parts, purchases parts from Caracol Company in Mexico for 100,000 Pesos on credit. Payment is due in 180 days

(October 8, 2008).The current exchange rate is $1 = 9.5000 pesos.

Prepare Madh’s journal entry on 4/1/08.

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Cash Flow Hedge - Date of Transaction Example

Assume that Madh takes a 180-day forward contract to buy 100,000 pesos.

The forward contract rate is 9.7400 pesos = $1.

Assume that Madh takes a 180-day forward contract to buy 100,000 pesos.

The forward contract rate is 9.7400 pesos = $1.

This is an executory contract, so no entry is made on the contract

date.


date.

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Cash Flow Hedge - Interim Reporting Date Example

At Madh’s year-end, 6/30/08, the value of the foreign currency payable must be re-measured, or

adjusted, based on the 6/30/08 spot rate of $1 = 9.5250 pesos.

1. re-measure the original payable:

At Madh’s year-end, 6/30/08, the value of the foreign currency payable must be re-measured, or

adjusted, based on the 6/30/08 spot rate of $1 = 9.5250 pesos.

1. re-measure the original payable:

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2. In addition, we record an entry to Accumulated Other Comprehensive Income (AOCI) to offset the

exchange gain/loss associated with the original transaction.

2. In addition, we record an entry to Accumulated Other Comprehensive Income (AOCI) to offset the

exchange gain/loss associated with the original transaction.

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Also, on 6/30/08, the forward contract must be recorded. The available forward rate to October 8, 2008 is $1 = 9.6200 pesos. Madh uses a 6%

discount rate.3. Record the forward contract:

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4. Finally, we have to amortize the discount from the original transaction date.

In the original transaction, we had a discount of $11 ($10,267 - $10,256). Amortize the discount using

the straight-line method.

4. Finally, we have to amortize the discount from the original transaction date.

In the original transaction, we had a discount of $11 ($10,267 - $10,256). Amortize the discount using

the straight-line method.

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Cash Flow Hedge - Date of Collection Example

On 10/8/08, both the original receivable and the exchange contract come due. Assume the 10/8/08

exchange rate is $1 = 9.4000 pesos.1. re-measure the Accounts Payable:

On 10/8/08, both the original receivable and the exchange contract come due. Assume the 10/8/08

exchange rate is $1 = 9.4000 pesos.1. re-measure the Accounts Payable:

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2. As at year-end, Madh must record an entry to offset the

foreign exchange loss of $139.

2. As at year-end, Madh must record an entry to offset the

foreign exchange loss of $139.

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On 10/8/08, both the original payable and the exchange contract come due. The 10/8/08

exchange rate is $1 = 9.4000 pesos. .3. Adjust the Forward Contract:


exchange rate is $1 = 9.4000 pesos. .3. Adjust the Forward Contract:

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4. Finally, Madh must amortize the rest of the discount from the original transaction date.

In the original transaction, Madh had a discount of $11 ($10,267 - $10,256). The discount is

amortized using the straight-line method.

4. Finally, Madh must amortize the rest of the discount from the original transaction date.

In the original transaction, Madh had a discount of $11 ($10,267 - $10,256). The discount is

amortized using the straight-line method.

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exchange rate is $1 = 9.4000 pesos.5. Purchase the 100,000 pesos:


exchange rate is $1 = 9.4000 pesos.5. Purchase the 100,000 pesos:

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exchange rate is $1 = 9.4000 pesos.6. Complete the Forward Contract Payable:


exchange rate is $1 = 9.4000 pesos.6. Complete the Forward Contract Payable:

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Fair Value Hedge - Date of Transaction Example

On 12/1/08, Castor Co., a U.S. confectioner sells cookies to L’Orignal, a French company, for 20,000 Euro’s (€)

on credit. Payment is due in 90 days (March 1, 2009).

Assume the current exchange rate is $.9700 = 1 €.Prepare Castor Co.’s journal entry.

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Fair Value Hedge - Date of Transaction Example

Castor Co. buys a 90-day forward contract to pay 20,000 €. Castor contracts for the 90-day forward rate on 12/1/08 at $.9500 = 1

€.

Castor Co. buys a 90-day forward contract to pay 20,000 €. Castor contracts for the 90-day forward rate on 12/1/08 at $.9500 = 1

€.


date.


date.

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Fair Value Hedge - Interim Reporting Date Example

On 12/31/08, the value of the foreign currency receivable must be adjusted based on the 12/31/08

spot rate of $.9650 = 1 €. Adjust the original receivable:

On 12/31/08, the value of the foreign currency receivable must be adjusted based on the 12/31/08

spot rate of $.9650 = 1 €. Adjust the original receivable:

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Fair Value Hedge - Interim Reporting Date Example

Also, on 12/31/08, the forward contract must be recorded. The available forward rate to March 1, 2009 is $.9520 = 1 €. Castor uses

a 6% discount rate. Record the forward contract:

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Fair Value Hedge - Date of Collection Example

On 3/1/09, both the original receivable and the forward contract come due. The 3/1/09 exchange rate is

$.9540 = 1 €.1. Adjust the Accounts Receivable:


$.9540 = 1 €.1. Adjust the Accounts Receivable:

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$.9540 = 1 €. Adjust the Forward Contract Payable:


$.9540 = 1 €. Adjust the Forward Contract Payable:

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$.9540 = 1 €.3. Collect the 20,000 € in settlement of the Account

Receivable:


$.9540 = 1 €.3. Collect the 20,000 € in settlement of the Account

Receivable:

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$.9540 = 1 €.4. Complete the Forward Contract:


$.9540 = 1 €.4. Complete the Forward Contract:

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Using a Foreign Currency Option as a Hedge

• An option is a contract that allows you to exercise a predetermined exchange rate if it is to your advantage.

• Options carry a cost.

• An option is a contract that allows you to exercise a predetermined exchange rate if it is to your advantage.

• Options carry a cost.

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As with forward contracts, options can be designed as cash flow hedges or fair

value hedges.

Option prices are determined using the Black-Scholes Option Pricing Model covered in most finance texts.

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Option values

• Derived from a function combining:– The difference between current spot rate and

strike price– The difference between foreign and domestic

interest rates– The length of time to option expiration– The potential volatility of changes in the spot rate

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SFAS 133 requires that the option be 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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Under fair value hedge accounting:

(1) The gain/loss on the hedge is recognized currently in net

income.

(2) The gain/loss on the firm commitment attributable to

the hedged risk is also recognized currently in net

income.

Under fair value hedge accounting:

(1) The gain/loss on the hedge is recognized currently in net

income.

(2) The gain/loss on the firm commitment attributable to

the hedged risk is also recognized currently in net

income.

Hedge of a Foreign Currency Firm Commitment

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

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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Foreign Currency Firm Commitment - Example

On December 1, 2008, Mawr receives an order from a German customer. The delivery date is March

1, 2009, when Mawr will receive immediate payment.

The sale is three months away, Mawr has a firm commitment to make the sale and receive

payment of 1,000,000 €.Mawr decides to hedge this commitment.

These are executory contracts, so no entries are made on this date.

These are executory contracts, so no entries are made on this date.

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Mawr will receive 1,000,000 € on March 1, 2009. A forward contract was entered into to sell the

euros at a price of $.905 = 1 €. Mawr’s discount rate is 12%.

On 12/31/08, the currently available forward rate is $.916 = 1 €.

1. Record the forward contract.




1. Record the forward contract.

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7-64







2. Record the firm commitment.




2. Record the firm commitment.

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On March 1, 2009, Mawr receives 1,000,000 € from the German customer upon

delivery of the order. On 3/1/09, the spot rate is $.900 = 1 €.

1. Adjust the forward contract to its current value of $5,000.



1. Adjust the forward contract to its current value of $5,000.

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2. Record an offsetting loss associated with the Firm Commitment.



2. Record an offsetting loss associated with the Firm Commitment.

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Foreign Currency Firm Commitment - ExampleOn March 1, 2009, Mawr receives 1,000,000

€ from the German customer upon delivery of the order. On 3/1/09, the spot

rate is $.900 = 1 €.3. Record the receipt of the foreign

currency.



3. Record the receipt of the foreign currency.

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4. Record the fulfillment of the forward contract.



4. Record the fulfillment of the forward contract.

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5. Close the Firm Commitment to Net Income.



5. Close the Firm Commitment to Net Income.

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Hedge of a Forecasted Foreign Currency Denominated Transaction

• SFAS 133 allows the use of cash flow hedge accounting for foreign currency derivatives associated with a forecasted foreign currency transaction– The forecasted transaction must be probable– The hedge must be highly effective– The hedging relationship must be properly

documented

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Hedge of a Forecasted Foreign Currency Denominated Transaction

• Accounting for a hedge of a forecasted transaction differs from that for a foreign currency firm commitment:– There is no recognition of the forecasted transaction or gains and

losses on it.– The company reports the hedging instrument at fair value, but does

not report changes in the fair value of the hedging instrument as gains and losses in net income. Instead, they are recorded in other comprehensive income. On the projected date of the forecasted transaction, the cumulative change in the fair value of the hedging instrument is transferred from other comprehensive income to net income.

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An Interesting Footnote

When foreign currency loans are made on a long-term basis to a foreign branch, subsidiary or equity method affiliate, SFAS 52 requires that foreign exchange gains and losses be deferred in other comprehensive income until the loan is repaid. Only the forex gains and losses related to the interest receivable are currently recorded in net income.

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Summary• The existence of different currencies creates an accounting

challenge when transactions are denominated in currencies different from those used to keep accounting records

• FASB has adopted a “two-transaction” approach, separating the actual sale or purchase transaction from the currency exchange “speculation”

• A variety of hedging practices may be used to reduce foreign currency exchange risk. The two most popular hedging instruments are foreign currency options and foreign currency forward contracts

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Possible Criticisms

• Some critics deride the “two transaction” approach adopted by the FASB, arguing that a single transaction has actually occurred.

• Some financial experts feel that the FASB’s definition of what constitutes a hedge is far too narrow.

• There is considerable controversy concerning the appropriate means of valuing options.

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emba module 8

Documents

purchase of foreign

foreign currency transactions

sale of foreign currency

particular foreign currency

foreign exchange riskattempt

foreign exchange ratesas

contracted exchange

countrys currency