1. Foreign Currency Transactions and Hedging Foreign Exchange Risk
Chapter Nine
Foreign Currency Transactions and Hedging Foreign Exchange Risk

2. Exchange Rate Mechanisms
Independent
Float
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.
EURO
Dollars
Pegged to
Another Currency

3. 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.

4. 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.”

5. 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.”
These are
wholesale
prices.
Retail prices
are higher.

6. 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. 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.

8. Foreign Exchange Forward Contracts
A forward contract requires the purchase (or sale) of currency units at a future date at the contracted exchange rate.
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!

9. 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 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!

10. 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
Remember: An option gives the holder “the right but not the obligation” to trade the foreign currency in the future

11. 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?

12. Foreign Currency Transactions
FASB No. 52
Requires a two-transaction perspective.
Account for the original sale in US $
Account for gains/losses from exchange rate fluctuations.

13. 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) . . . ?

14. 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” ?

15. 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 number of foreign currency units that $1 will buy, the rate is called an
“INDIRECT QUOTE”

16. Foreign Exchange Transaction Example
On 12/1/07, 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 = £.
Prepare BobCo’s journal entry.

17. Foreign Exchange Transaction Example
On 12/31/07, the exchange rate is $1 = £.
At the balance sheet date we have to “remeasure”, or adjust, the original A/R to the current exchange rate.

18. Foreign Exchange Transaction Example
On 3/1/08, Coventry Corp. pays BobCo the 10,000 £ for the 12/1/07 sale.
The exchange rate on 3/1/08, was $1 = £.
On 3/1/08, we have to do TWO things.
First, we must “remeasure” the A/R.

19. Foreign Exchange Transaction Example
On 3/1/08, Coventry Corp. pays BobCo the 10,000 £ for the 12/1/07 sale.
The exchange rate on 3/1/08, was $1 = £.
On 3/1/08, we have to do TWO things.
Second, we must record receipt of the £.

20. 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.

21. 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

22. Accounting for Derivatives
SFAS 133 provides guidance for hedges of four types of foreign exchange risk.
Forecasted foreign currency denominated transactions.
Recognized foreign currency denominated assets & liabilities.
Net investments in foreign operations
Unrecognized foreign currency firm commitments.

23. 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. ?

24. Determining the Value of Derivatives
To determine the value of foreign currency derivatives, the company needs 3 basic pieces of information:
The forward rate when the forward contract was entered into.
The current forward rate for a contract that matures on the same date as the forward contract.
A discount rate.

25. Accounting for Hedges
As the Fair Value of a forward contract changes, gains or losses are recorded.
On 12/31/06, Bob has a forward contract to deliver 500,000¥ to Inuwashi Company on 1/31/06 at 120¥ = $1. The available 31-day forward rate on 12/31/06 is ¥ = $1.
Bob uses a discount rate of 6%. What is the value of the forward contract on 12/31/06? ?

26. 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

27. Let’s try a Cash Flow Hedge Example

28. Cash Flow Hedge - Date of Transaction Example
On 4/1/07, MPG, Inc., a U.S. maker of auto parts, purchases parts from Aguila Company in Mexico for 100,000 Pesos on credit. Payment is due in 180 days (October 8, 2007).
The current exchange rate is $1 = pesos.
Prepare MPG’s journal entry on 4/1/07.

29. Cash Flow Hedge - Date of Transaction Example
Assume that MPG 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.

30. Cash Flow Hedge - Interim Reporting Date Example
At MPG’s year-end, 6/30/07, the value of the foreign currency payable must be re-measured, or adjusted, based on the 6/30/07 spot rate of $1 = pesos.
Remeasure the original payable:

31. Cash Flow Hedge - Interim Reporting Date Example
In addition, we record an entry to Accumulated Other Comprehensive Income (AOCI) to offset the exchange gain/loss associated with the original transaction.

32. Cash Flow Hedge - Interim Reporting Date Example
Also, on 6/30/07, the forward contract must be recorded. The available forward rate to October 8, 2007 is $1 = pesos. MPG uses a 6% discount rate.
Record the forward contract:

33. Cash Flow Hedge - Interim Reporting Date Example
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.

34. Cash Flow Hedge - Date of Collection Example
On 10/8/07, both the original receivable and the exchange contract come due. The 10/8/07 exchange rate is $1 = pesos.
Remeasure the Accounts Payable:

35. Cash Flow Hedge - Date of Collection Example
As at year-end, MPG must record an entry to offset the foreign exchange loss of $139.

36. Cash Flow Hedge - Date of Collection Example
On 10/8/07, both the original payable and the exchange contract come due. The 10/8/07 exchange rate is $1 = pesos. .
Adjust the Forward Contract:

37. Cash Flow Hedge - Date of Collection Example
Finally, we have to amortize the rest of 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.

38. Cash Flow Hedge - Date of Collection Example
On 10/8/07, both the original payable and the exchange contract come due. The 10/8/07 exchange rate is $1 = pesos.
Purchase the 100,000 pesos:

39. Cash Flow Hedge - Date of Collection Example
On 10/8/07, both the original payable and the exchange contract come due. The 10/8/07 exchange rate is $1 = pesos.
Complete the Forward Contract Payable:

40. Now, let’s try a Fair Value Hedge.

41. Fair Value Hedge - Date of Transaction Example
On 12/1/07, Balloon Co., a U.S. balloon manufacturer sells balloons to Rue Maison, a French company, for 20,000 Euro’s (€) on credit. Payment is due in 90 days (March 1, 2008).
The current exchange rate is $.9700 = 1 €.
Prepare Balloon Co.’s journal entry.

42. Fair Value Hedge - Date of Transaction Example
Balloon Co buys a 90-day forward contract to pay 20,000 €. Balloon contracts for the 90-day forward rate on 12/1/07 of $.9500 = 1 €.
This is an executory contract, so no entry is made on the contract date.

43. Fair Value Hedge - Interim Reporting Date Example
On 12/31/07, the value of the foreign currency receivable must be adjusted based on the 12/31/07 spot rate of $.9650 = 1 €.
Adjust the original receivable:

44. Fair Value Hedge - Interim Reporting Date Example
Also, on 12/31/07, the forward contract must be recorded. The available forward rate to March 1, 2008 is $.9520 = 1 €. Balloon uses a 6% discount rate.
Record the forward contract:

45. Fair Value Hedge - Date of Collection Example
On 3/1/08, both the original receivable and the forward contract come due. The 3/1/08 exchange rate is $.9540 = 1 €.
Adjust the Accounts Receivable:

46. Fair Value Hedge - Date of Collection Example
On 3/1/08, both the original receivable and the forward contract come due. The 3/1/08 exchange rate is $.9540 = 1 €.
Adjust the Forward Contract Payable:

47. Fair Value Hedge - Date of Collection Example
On 3/1/08, both the original receivable and the forward contract come due. The 3/1/08 exchange rate is $.9540 = 1 €.
Collect the 20,000 € in settlement of the Account Receivable:

48. Fair Value Hedge - Date of Collection Example
On 3/1/08, both the original receivable and the forward contract come due. The 3/1/08 exchange rate is $.9540 = 1 €.
Complete the Forward Contract:

49. 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.

50. 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.

51. 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

52. 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

53. 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.
Under fair value hedge accounting:
The gain/loss on the hedge is recognized currently in net income.
The gain/loss on the firm commitment attributable to the hedged risk is also recognized currently in net income.

54. Foreign Currency Firm Commitment - Example
On December 1, 2007, Amerco receives an order from a German customer. The delivery date is March 1, 2008, when Amerco will receive immediate payment.
The sale is three months away, Amerco has a firm commitment to make the sale and receive payment of 1,000,000 €.
Amerco decides to hedge this commitment.
These are executory contracts, so no entries are made on this date.

55. Foreign Currency Firm Commitment - Example
Amerco will receive 1,000,000 € on March 1, A forward contract was entered into to sell the euros at a price of $.905 = 1 €. Amerco’s discount rate is 12%.
On 12/31/07, the currently available forward rate is $.916 = 1 €.
Record the forward contract.

56. Foreign Currency Firm Commitment - Example

57. Foreign Currency Firm Commitment - Example
Amerco will receive 1,000,000 € on March 1, A forward contract was entered into to sell the euros at a price of $.905 = 1 €. Amerco’s discount rate is 12%.
On 12/31/07, the currently available forward rate is $.916 = 1 €.
Record the firm commitment.

58. Foreign Currency Firm Commitment - Example
On March 1, 2008, Amerco receives 1,000,000 € from the German customer upon delivery of the order. On 3/1/08, the spot rate is $.900 = 1 €.
Adjust the forward contract to its current value of $5,000.

59. Foreign Currency Firm Commitment - Example
On March 1, 2008, Amerco receives 1,000,000 € from the German customer upon delivery of the order. On 3/1/08, the spot rate is $.900 = 1 €.
Record an offsetting loss associated with the Firm Commitment.

60. Foreign Currency Firm Commitment - Example
On March 1, 2008, Amerco receives 1,000,000 € from the German customer upon delivery of the order. On 3/1/08, the spot rate is $.900 = 1 €.
Record the receipt of the foreign currency.

61. Foreign Currency Firm Commitment - Example
On March 1, 2008, Amerco receives 1,000,000 € from the German customer upon delivery of the order. On 3/1/08, the spot rate is $.900 = 1 €.
Record the fulfillment of the forward contract.

62. Foreign Currency Firm Commitment - Example
On March 1, 2008, Amerco receives 1,000,000 € from the German customer upon delivery of the order. On 3/1/08, the spot rate is $.900 = 1 €.
Close the Firm Commitment to Net Income.

63. 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

64. 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
WHAT DO YOU THINK???

65. The End . . .
. . . sort of