© The McGraw-Hill Companies, Inc., 2004 Slide 9-1 McGraw-Hill/Irwin Chapter Nine Foreign Currency...
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© The McGraw-Hill Companies, Inc., 2004 Slide 9-1 McGraw-Hill/Irwin Chapter Nine Foreign Foreign Currency Currency Transactions Transactions and Hedging and Hedging Foreign Foreign Exchange Risk Exchange Risk
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Transcript of © The McGraw-Hill Companies, Inc., 2004 Slide 9-1 McGraw-Hill/Irwin Chapter Nine Foreign Currency...
© The McGraw-Hill Companies, Inc., 2004
Slide 9-1
McGraw-Hill/Irwin
Chapter Nine
Foreign Foreign Currency Currency
Transactions Transactions and Hedging and Hedging
Foreign Foreign Exchange RiskExchange Risk
© The McGraw-Hill Companies, Inc., 2004
Slide 9-2
McGraw-Hill/Irwin
Foreign 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.
© The McGraw-Hill Companies, Inc., 2004
Slide 9-3
McGraw-Hill/Irwin
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.
© The McGraw-Hill Companies, Inc., 2004
Slide 9-4
McGraw-Hill/Irwin
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
Remember – Rates change constantly during the day
Exchange rates are published daily in the Wall Street Journal. These are “end-of-
day” rates. As of 4:00pm Eastern
time
Remember – Rates change constantly during the day
© The McGraw-Hill Companies, Inc., 2004
Slide 9-5
McGraw-Hill/Irwin
Foreign 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.
As the relative strength of a country’s economy
changes . . .
. . . the exchange rate of the local currency relative to
other currencies also fluctuates.
© The McGraw-Hill Companies, Inc., 2004
Slide 9-6
McGraw-Hill/Irwin
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 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.
© The McGraw-Hill Companies, Inc., 2004
Slide 9-7
McGraw-Hill/Irwin
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 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.
© The McGraw-Hill Companies, Inc., 2004
Slide 9-8
McGraw-Hill/Irwin
Foreign Currency Transactions
A U.S. company buys or sells goods or services to a party in another country.
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?
© The McGraw-Hill Companies, Inc., 2004
Slide 9-9
McGraw-Hill/Irwin
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.
© The McGraw-Hill Companies, Inc., 2004
Slide 9-10
McGraw-Hill/Irwin
?
Foreign Currency Transactions
. . . but the cash flow . . . but the cash flow is at a later date . . .is at a later date . . .
. . . fluctuating . . . fluctuating exchange rates can exchange rates can result in exchange result in exchange
rate gains or losses.rate gains or losses.
When a transaction When a transaction occurs on one date occurs on one date
(for example a (for example a credit sale) . . .credit sale) . . .
© The McGraw-Hill Companies, Inc., 2004
Slide 9-11
McGraw-Hill/Irwin
?
Foreign Currency Transactions
When 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 currency, the
rate is called a“DIRECT QUOTE”
© The McGraw-Hill Companies, Inc., 2004
Slide 9-12
McGraw-Hill/Irwin
Foreign Currency Transactions
When 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 currency, the
rate is called a“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”
© The McGraw-Hill Companies, Inc., 2004
Slide 9-13
McGraw-Hill/Irwin
Foreign Exchange Transaction Example
On 12/1/04, 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 = .6425 £.
Prepare BobCo’s journal entry.
On 12/1/04, 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 = .6425 £.
Prepare BobCo’s journal entry.
© The McGraw-Hill Companies, Inc., 2004
Slide 9-14
McGraw-Hill/Irwin
Foreign Exchange Transaction Example
On 12/31/04, the exchange rate is $1 = .6400 £.
At the balance sheet date we have to “remeasure”, or adjust, the original A/R to
the current exchange rate.
On 12/31/04, the exchange rate is $1 = .6400 £.
At the balance sheet date we have to “remeasure”, or adjust, the original A/R to
the current exchange rate.
© The McGraw-Hill Companies, Inc., 2004
Slide 9-15
McGraw-Hill/Irwin
Foreign Exchange Transaction Example
On 3/1/05, Coventry Corp. pays BobCo the 10,000 £ for the 12/1/04 sale.
The exchange rate on 3/1/05, was $1 = .6500 £.
On 3/1/05, we have to do TWO things.
First, we have to “remeasure” the A/R.
© The McGraw-Hill Companies, Inc., 2004
Slide 9-16
McGraw-Hill/Irwin
Foreign Exchange Transaction Example
On 3/1/05, Coventry Corp. pays BobCo the 10,000 £ for the 12/1/04 sale.
The exchange rate on 3/1/05, was $1 = .6500 £.
On 3/1/05, we have to do TWO things.
Second, we have record the receipt of the £.
© The McGraw-Hill Companies, Inc., 2004
Slide 9-17
McGraw-Hill/Irwin
Hedging Foreign Exchange Risk
To 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.
© The McGraw-Hill Companies, Inc., 2004
Slide 9-18
McGraw-Hill/Irwin
Hedging Foreign Exchange Risk
To hedge a foreign currency transaction, companies use foreign currency derivatives
Two most common tools: Foreign currency
forward contracts Foreign currency
options
