McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. EMBA Module 8 Foreign Currency Transactions and Hedging Foreign Exchange Risk

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 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. 7-2

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 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. 7-3

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 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.” 7-4

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 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.” 7-5

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Foreign Exchange Rates As the relative strength of a country’s economy changes the exchange rate of the local currency relative to other currencies also fluctuates. ?¥ = $? 7-6

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 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. 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. 7-7

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 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. 7-8

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. An alternative is an option contract to purchase 1,000,000 ¥ at $.0080 US in 30 days. But it costs $ 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. 7-9

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 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.) 7-10

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 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 Risk Currency 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 = Y 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!

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 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? 7-20

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Foreign Currency Transactions FASB No. 52 Requires a two-transaction perspective. (1)Account for the original sale in US $ (2)Account for gains/losses from exchange rate fluctuations. FASB No. 52 Requires a two-transaction perspective. (1)Account for the original sale in US $ (2)Account for gains/losses from exchange rate fluctuations. 7-21

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. ? Foreign Currency Transactions... but the cash flow is at a later date fluctuating exchange rates can result in exchange rate gains or losses. When a transaction occurs on one date (for example a credit sale)

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. ? 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” 7-23

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 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” 7-24

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 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. 7-25

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 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. 7-26

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Foreign Exchange Transaction Example On 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. 7-27

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Foreign Exchange Transaction Example On 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 £. 7-28

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 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. 7-29

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 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. 7-30

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 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 7-31

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Accounting for Derivatives SFAS 133 provides guidance for hedges of four types of foreign exchange risk. Recognized foreign currency denominated assets & liabilities. Forecasted foreign currency denominated transactions. Unrecognized foreign currency firm commitments. Net investments in foreign operations 7-32

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 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. ? 7-33

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Determining the Value of Derivatives 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. 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. 7-34

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Accounting for Hedges 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 ¥ = $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 ¥ = $1. Chan uses a discount rate of 6%. What is the value of the forward contract on 12/31/08? ? 7-35

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 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 7-36

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 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 = pesos. Prepare Madh’s journal entry on 4/1/

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 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 pesos = $1. This is an executory contract, so no entry is made on the contract date. 7-38

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 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 = 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 = pesos. 1.re-measure the original payable: 7-39

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Cash Flow Hedge - Interim Reporting Date Example 2.In addition, we record an entry to Accumulated Other Comprehensive Income (AOCI) to offset the exchange gain/loss associated with the original transaction. 7-40

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Cash Flow Hedge - Interim Reporting Date Example Also, on 6/30/08, the forward contract must be recorded. The available forward rate to October 8, 2008 is $1 = pesos. Madh uses a 6% discount rate. 3.Record the forward contract: 7-41

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Cash Flow Hedge - Interim Reporting Date Example 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. 7-42

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 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 = 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 = pesos. 1.re-measure the Accounts Payable: 7-43

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Cash Flow Hedge - Date of Collection Example 2.As at year-end, Madh must record an entry to offset the foreign exchange loss of $

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Cash Flow Hedge - Date of Collection Example On 10/8/08, both the original payable and the exchange contract come due. The 10/8/08 exchange rate is $1 = pesos.. 3.Adjust the Forward Contract: On 10/8/08, both the original payable and the exchange contract come due. The 10/8/08 exchange rate is $1 = pesos.. 3.Adjust the Forward Contract: 7-45

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Cash Flow Hedge - Date of Collection Example 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. 7-46

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Cash Flow Hedge - Date of Collection Example On 10/8/08, both the original payable and the exchange contract come due. The 10/8/08 exchange rate is $1 = pesos. 5.Purchase the 100,000 pesos: On 10/8/08, both the original payable and the exchange contract come due. The 10/8/08 exchange rate is $1 = pesos. 5.Purchase the 100,000 pesos: 7-47

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Cash Flow Hedge - Date of Collection Example On 10/8/08, both the original payable and the exchange contract come due. The 10/8/08 exchange rate is $1 = pesos. 6.Complete the Forward Contract Payable: On 10/8/08, both the original payable and the exchange contract come due. The 10/8/08 exchange rate is $1 = pesos. 6.Complete the Forward Contract Payable: 7-48

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 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. 7-49

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 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 €. This is an executory contract, so no entry is made on the contract date. 7-50

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 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: 7-51

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 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: 7-52

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 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: 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: 7-53

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 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 €.  Adjust the Forward Contract Payable: On 3/1/09, both the original receivable and the forward contract come due. The 3/1/09 exchange rate is $.9540 = 1 €.  Adjust the Forward Contract Payable: 7-54

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 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 €. 3.Collect the 20,000 € in settlement of the Account Receivable: On 3/1/09, both the original receivable and the forward contract come due. The 3/1/09 exchange rate is $.9540 = 1 €. 3.Collect the 20,000 € in settlement of the Account Receivable: 7-55

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 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 €. 4.Complete the Forward Contract: On 3/1/09, both the original receivable and the forward contract come due. The 3/1/09 exchange rate is $.9540 = 1 €. 4.Complete the Forward Contract: 7-56

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 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. 7-57

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Using a Foreign Currency Option as a Hedge 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. 7-58

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 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 7-59

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Using a Foreign Currency Option as a Hedge 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 7-60

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 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. Example Ruff 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. Example Ruff 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. 7-61

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 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. 7-62

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Foreign Currency Firm Commitment - Example Mawr will receive 1,000,000 € on March 1, 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. Mawr will receive 1,000,000 € on March 1, 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. 7-63

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Foreign Currency Firm Commitment - Example 7-64

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Foreign Currency Firm Commitment - Example Mawr will receive 1,000,000 € on March 1, 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 €. 2.Record the firm commitment. Mawr will receive 1,000,000 € on March 1, 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 €. 2.Record the firm commitment. 7-65

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Foreign Currency Firm Commitment - Example 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. 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,

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Foreign Currency Firm Commitment - Example 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 €. 2.Record an offsetting loss associated with the Firm Commitment. 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 €. 2.Record an offsetting loss associated with the Firm Commitment. 7-67

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Foreign Currency Firm Commitment - Example 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 €. 3.Record the receipt of the foreign currency. 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 €. 3.Record the receipt of the foreign currency. 7-68

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Foreign Currency Firm Commitment - Example 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 €. 4.Record the fulfillment of the forward contract. 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 €. 4.Record the fulfillment of the forward contract. 7-69

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Foreign Currency Firm Commitment - Example 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 €. 5.Close the Firm Commitment to Net Income. 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 €. 5.Close the Firm Commitment to Net Income. 7-70

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 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 7-71

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 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. 7-72

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 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. 7-73

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 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 7-74

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 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. 7-75