Derivatives and Foreign Currency: Concepts and Common Transactions Chapter 12 Derivatives and Foreign Currency: Concepts and Common Transactions Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall 1

Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall Derivatives and Foreign Currency – Concepts and Common Transactions: Objectives Understand the definition of a derivative and the types of risks that derivatives can manage. Understand the structure, benefits and costs of options, futures, forward contracts, and swaps. Understand key concepts related to foreign currency exchange rates, such as indirect and direct quotes; floating, fixed, and multiple exchange rates; and spot, current, and historical exchange rates. Explain the difference between receivable or payable measurement and denomination. Record foreign currency-denominated sales/receivables and purchases/payables at the initial transaction date, year-end, and the receivable or payable settlement date. Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall Derivatives and Foreign Currency: Concepts and Common Transactions 1: DERIVATIVES Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Derivative (definition) The name given to a broad range of financial securities. The derivative's value to the investor is directly related to fluctuations in price, rate or some other variable that underlies it. A derivative can be used to offset (“hedge”) the potential fluctuation in Interest rates Commodity prices Foreign currency exchange rates Stock prices Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Using Derivatives as Hedges A hedge can Shift risk of fluctuations in sales prices, costs, interest rates, or currency exchange rates Help manage costs Reduce risks to improve financial position Produce tax benefits Help avoid bankruptcy Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall Derivatives and Foreign Currency: Concepts and Common Transactions 2: Types of DERIVATIVES Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall Derivatives The four basic types of derivatives are: Forward Contracts Futures Contracts Options Swaps Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall Forward Contracts Forward Contracts are Negotiated contracts between two parties For the delivery or purchase of A commodity or A foreign currency At an agreed upon price, quantity, and delivery date. Settlement of the forward contract may be Physical delivery of the good, or Net settlement Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall Futures Contracts Futures contracts are a specific type of forward contract Characteristics are standardized Characteristics are set by futures exchanges (Rather than by the contracting parties) so performance risk is eliminated Exchange guarantees performance Settlement may also be made by entering another futures contract in the opposite direction. Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall Options Options are right (but not the obligation) to either Call (buy), or Put (sell) With options, only one party is obligated to perform depending on the election of the other party to exercise their option. Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall Swaps Swaps are contracts to exchange an ongoing stream of cash flows, commonly swapping interest rates. Swap variable- for fixed-rate debt, or Swap fixed- for variable-rate debt Swaps are commonly negotiated on an individual basis like forward contracts, but may be standardized and exchange-traded like futures. Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Example: Forward Contract Sam decides to sell future production by entering into a forward contract with Irene for delivery of 10,000 items in one year at a price of $10 per item. Thus, Sam has determined their selling price regardless of the market, and Irene has locked in her purchase price. Sam risks loss of potential revenue if the market price for the items increases in the next year. Irene risks loss of potential savings if the market price for the items decreases in the next year. Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Forward Contract Impact If Sam’s fixed costs are $50,000, and the variable cost is $3 per unit, Sam will lock in profit of $20,000 ($100,000 revenue less $50,000 fixed costs less $30,000 variable costs). If the market price for the item increases, Sam can sell at the higher market price and settle with Irene by paying her the difference, or simply sell the items to Irene at the contracted price. Either way, Sam has profit of $20,000. Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

3: Foreign currency exchange Derivatives and Foreign Currency: Concepts and Common Transactions 3: Foreign currency exchange Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Measurement and Denomination Measured in a currency Recorded in the financial records in that currency Denominated in a currency Requires settlement (payment or receipt) in that currency For U.S. firms U.S. dollar is the measurement currency Payables and receivables may be denominated in U.S. dollars or other currencies Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Quoting Exchange Rates Direct quotation (U.S. dollars per one foreign currency unit) $1.60 (U.S. dollars) for £1 (British pound) Indirect quotation (foreign currency units per one U.S. dollar) £0.625 (British pounds) for $1 (U.S. dollar) Direct and indirect quotes are reciprocals £1 / $1.60 = £0.625 $1 / £0.625 = $1.60 Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Establishing Exchange Rates Exchange rates may be fixed by a governmental unit or may be allowed to fluctuate (float) with changes in the currency markets. Official (fixed) exchange rates are set by a government and do not fluctuate with the changes in the world currency markets. Free (floating) exchange rates reflect the fluctuating market prices for a currency based on supply and demand and other factors in the world currency markets. Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Various Exchange Rates Spot rate Exchange rate for immediate delivery Current rate Exchange rate at balance sheet date, or Exchange rate at the time a transaction takes place Historical rate Exchange rate that existed when a specific transaction or event occurred Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

4: Sales and purchases denominated in foreign currency Derivatives and Foreign Currency: Concepts and Common Transactions 4: Sales and purchases denominated in foreign currency Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Currency Denomination A company’s functional currency is the currency in which they transact the majority of their business. A foreign currency transaction is any transaction that is measured and settled (“denominated”) in a currency other than the company’s functional currency. Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall Foreign Exchange Risk Foreign Exchange Risk is the risk that the functional currency and the currency used in the transaction will change in value compared to each other, and the company will lose money as a result. Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

5: Recording foreign currency transactions Derivatives and Foreign Currency: Concepts and Common Transactions 5: Recording foreign currency transactions Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Foreign Currency Purchases Purchases on account denominated in a foreign currency are subject to risk. Changes in the foreign exchange rate may Increase Accounts Payable, resulting in an exchange loss, or Decrease Accounts Payable, resulting in an exchange gain Foreign currency Accounts Payable is adjusted to fair value each period until paid. Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Foreign Currency Sales Sales on account denominated in a foreign currency are subject to risk. Changes in the foreign exchange rate may Increase Accounts Receivable, resulting in an exchange gain, or Decrease Accounts Receivable, resulting in an exchange loss Foreign currency Accounts Receivable is adjusted to fair value each period until collected. Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Example: Purchase on Account On 11/1, Sam purchases inventory for 500 euros on account. Sam pays for these goods on 1/30. Pertinent rates: Date Spot rate Acct Pay Gain (Loss) 11/1 $1.35 $675   12/31 $1.36 $680 $(5) 1/30 $1.38 $690 $(10) Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Purchase on Account - Entries 11/1 Inventory 675   Account Payable(euros) 12/31 Exchange loss 5 1/30 Cash (euros) 690 Cash ($)   1/30 Account Payable (euros) 680   10 Adjust payable to current rate. Convert dollars to euros so proper funds are available for payment. Make payment in euros, recognizing additional loss. Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Example: Sale on Account On 11/1, Sam sells goods for 500 euros on account. The customer pays on 1/30 and cash is converted on that date. Pertinent rates: Date Spot rate Acct Rec Gain (Loss) 11/1 $1.35 $675   12/31 $1.36 $680 $5 1/30 $1.38 $690 $10 Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Sale on Account - Entries 11/1 Accounts receivable (euros) 675   Sales 12/31 5 Exchange gain 1/30 Cash (euros) 690 Acct receivable (euros) 680 10 Cash ($) Adjust receivable to current rate. Collect from customer, recognizing additional gain Convert funds. Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall