© The McGraw-Hill Companies, Inc., 2001 Slide 9-1 McGraw-Hill/Irwin 9 C H A P T E R Foreign...

© The McGraw-Hill Companies, Inc., 2001

Slide 9-1

McGraw-Hill/Irwin

9

C H A P T E R

Foreign Currency Transactions and Hedging Foreign Exchange Risk


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Foreign Exchange MarketsForeign Exchange Markets

Each country uses its own currency for internal economic transactions.

To make transactions in another country, units of that country’s currency must be acquired.

The cost of those currencies is called the exchange rate.

Each country uses its own currency for internal economic transactions.

To make transactions in another country, units of that country’s currency must be acquired.

The cost of those currencies is called the exchange rate.


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Exchange Rate MechanismsExchange 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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As 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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?


When a transaction occurs When a transaction occurs on one date (for example on one date (for example

a credit sale) . . .a credit sale) . . .

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

. . . fluctuating exchange rates . . . fluctuating exchange rates can result in exchange rate can result in exchange rate

gains or losses.gains or losses.


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Foreign Exchange Transaction Example


On 12/1/99, BobCo sells inventory to Coventry Corp. on credit. Coventry will pay BobCo

10,000 British pounds in 90 days.The current exchange rate is $1 = .6093 £.

Prepare BobCo’s journal entry.

On 12/1/99, BobCo sells inventory to Coventry Corp. on credit. Coventry will pay BobCo

10,000 British pounds in 90 days.The current exchange rate is $1 = .6093 £.

Prepare BobCo’s journal entry.


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On 3/1/00, Coventry Corp. pays BobCo the 10,000 £ for the 12/1/99 sale.

The exchange rate on 3/1/00, was $1 = .6115 £.First, adjust the original A/R to the current

exchange rate.


The exchange rate on 3/1/00, was $1 = .6115 £.First, adjust the original A/R to the current

exchange rate.


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The exchange rate on 3/1/00, was $1 = .6115 £.Second, record BobCo’s receipt of Coventry’s

payment.


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Foreign Exchange RatesForeign Exchange Rates

Spot Rates The exchange rate that is

available today.Forward Rates

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 Rates The exchange rate that is

available today.Forward Rates

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 Options Contracts


A forward contract requires the purchase of currency units at a future date at the contracted

exchange rate.

A forward contract requires the purchase 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!

An options contract gives the holder the option of buying the currency units at a future date at the

contracted “strike” price.

An options contract gives the holder the option of buying the currency units at a future date at the

contracted “strike” price.




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HedgingHedging

To control for the risk of exchange rate fluctuation,

a forward contract for currency can be

purchased.

Hedging effectively

eliminates the gain or loss exposure.


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Accounting for HedgesAccounting for Hedges

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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Accounting for HedgesAccounting 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 12/31/03, Bob has a forward contract to deliver 5,000 £ to Lord Ashton on 1/31/04 at .625 £ = $1. The 12/31 30-day forward rate

is .500 £ = $1. What is the gain or loss on the

forward contract for Bob?

On 12/31/03, Bob has a forward contract to deliver 5,000 £ to Lord Ashton on 1/31/04 at .625 £ = $1. The 12/31 30-day forward rate

is .500 £ = $1. What is the gain or loss on the

forward contract for Bob?

?


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Hedging - Date of TransactionExample


On 12/1/99, Balloon Co., a U.S. balloon manufacturer sells balloons to Maison Rue., a french company, for 10,200 french francs on

credit. Payment is due in 90 days.The current exchange rate is $1 = 4.800 FF.

Prepare Balloon Co.’s journal entry.


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Balloon Co buys a 90-day forward contract to sell 10,200 FF at the 90-day forward

rate on 12/1/99 of $1.00 = 5.000 FF.

Balloon Co buys a 90-day forward contract to sell 10,200 FF at the 90-day forward

rate on 12/1/99 of $1.00 = 5.000 FF.

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

date.

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

date.


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Hedging - Interim Reporting DateExample


On 12/31/99, the value of the foreign currency receivable must be adjusted based on the

12/31/99 spot rate of $1.00 = 5.258 FF. Adjust the original receivable:

On 12/31/99, the value of the foreign currency receivable must be adjusted based on the

12/31/99 spot rate of $1.00 = 5.258 FF. Adjust the original receivable:


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Also, on 12/31/99, the forward contract payable and gains/losses must be recorded. The 60-day

forward rate at 12/31/99 is $1 = 5.100 FF. Record the gain/loss on the forward contract

payable:


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Hedging - Date of CollectionExample


On 3/1/00, both the original receivable and the exchange contract come due. The 3/1/00

exchange rate is $1.00 = 5.400 FF. Adjust the Accounts Receivable:


exchange rate is $1.00 = 5.400 FF. Adjust the Accounts Receivable:


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exchange rate is $1.00 = 5.400 FF. Adjust the Forward Contract Payable:


exchange rate is $1.00 = 5.400 FF. Adjust the Forward Contract Payable:


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On 3/1/00, both the original receivable and the exchange contract come due. The 3/1/00 exchange

rate is $1.00 = 5.400 FF. Collect the 10,000 FF in settlement of the Account

Receivable:


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exchange rate is $1.00 = 5.400 FF. Complete the Forward Contract Payable:


exchange rate is $1.00 = 5.400 FF. Complete the Forward Contract Payable:


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Using a Foreign Currency Option as a Hedge

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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Accounting for a Foreign Currency Option Used as a Hedge


On 6/15/02, Jumbo Co., a U.S. company, bought inventory from MexTech a Mexican

seller. Jumbo agreed to pay MexTech 100,000 pesos in 30 days.

The current exchange rate is $.1050 = 1 peso.Prepare Jumbo’s journal entry.


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On 6/15, Jumbo bought an option contract to buy 100,000 pesos at the 30-day

forward rate of $.1075 = 1 peso. The contract cost $.002 per peso.

On 6/15, Jumbo bought an option contract to buy 100,000 pesos at the 30-day

forward rate of $.1075 = 1 peso. The contract cost $.002 per peso.


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On 6/30/02 (Jumbo’s year-end), the spot rate was $.1060. The option was valued was put at

$250. Adjust the original receivable:


$250. Adjust the original receivable:


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$250. Adjust the value of the option:


$250. Adjust the value of the option:


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On 7/15/02, the spot rate was $.1070. The option was not exercised, so it was allowed to expire

(implied value = $0). Adjust the value of the payable.


(implied value = $0). Adjust the value of the payable.


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Note: exercising the option would have cost $10,750, so Jumbo chose to ignore it.

Note: exercising the option would have cost $10,750, so Jumbo chose to ignore it.


(implied value = $0). Buy pesos at the spot rate.


(implied value = $0). Buy pesos at the spot rate.


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(implied value = $0). Pay the A/P using the pesos.


(implied value = $0). Pay the A/P using the pesos.


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Since the option was not exercised, and it was allowed to expire (implied value = $0), Jumbo

must write it off as a loss. Write off the Option.

Since the option was not exercised, and it was allowed to expire (implied value = $0), Jumbo

must write it off as a loss. Write off the Option.


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Hedge accounting is only allowed under 2 conditions:

1. There is formal documentation of the

hedge.2. The hedge is expected to

be highly effective.

Hedge accounting is only allowed under 2 conditions:

1. There is formal documentation of the

hedge.2. The hedge is expected to

be highly effective.

Hedge of a Future Foreign Currency Commitment

Hedge of a Future Foreign Currency 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 a 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 a 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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The End . . .

. . . sort of

© The McGraw-Hill Companies, Inc., 2001 Slide 9-1 McGraw-Hill/Irwin 9 C H A P T E R Foreign...

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