1. Slide 17-1 17 CHAPTER 17 USING DERIVATIVES TO MANAGE FOREIGN CURRENCY EXPOSURES

2. Slide 17-2 17 Focus of Chapter 17 l Types of Foreign Exchange (FX) Exposure l The Concept and Technique of Hedging l Using FX Options to Hedge l Using FX Forwards to Hedge l Derivative Financial Instruments-- In General

3. Slide 17-3 17 The Technique of Hedging: A Way to Eliminate Risk lCreating a counterbalancing position to an FX exposure. l A loss on the exposed item will be offset by a gain on the counterbalancing position.

4. Slide 17-4 17 To Hedge or Not to Hedge: That Is the Question l Hedging is like taking an umbrella with you in case it rains.

5. Slide 17-5 17 The Technique of Hedging: The Alternative is Risky l Not hedging an FX exposure is gambling that the exchange rate will not change adversely.

6. Slide 17-6 17 FAS 133 Hedging Categories: “ The Four Amigos” l Undesignated Hedges l Fair Value Hedges l Cash Flow Hedges l Net Investment Hedges

7. Slide 17-7 17 FAS 133 Hedging Categories : Nature of Each Category l Undesignated Hedges: FX receivables & FX payables from exporting and importing. l Fair Value Hedges: Firm commitments & hedges of certain assets and liabilities. l Cash Flow Hedges: Forecasted transactions & hedges of certain assets and liabilities. l Net Investment Hedges: Investments in foreign subsidiaries (covered in Ch. 18).

8. Slide 17-8 17 FAS 133 Hedging Categories : Manner of Valuing Hedging Contracts l For all 4 categories: n Value the contract (an asset or liability depending on the situation) at fair value. s Use quotes or present value of future cash flows.

9. Slide 17-9 17 Undesignated Hedges: Reporting FX Gains & Losses l Report ALL FX gains and losses c urrently in earnings as they arise. l Thus no special accounting treatment (i.e., no “hedge accounting”).

10. Slide 17-10 17 Fair Value Hedges: Reporting FX Gains & Losses l Report ALL FX gains and losses c urrently in earnings as they arise. l Simultaneously, recognize in earnings an FX loss or gain on the hedged item. n This is a special accounting treatment (“hedge accounting”).

11. Slide 17-11 17 Cash Flow Hedges: Reporting FX Gains & Losses l Report ALL FX gains and losses c urrently in OCI as they arise. l When the hedged item is recorded in earnings, transfer the OCI item to earnings. n This is a special accounting treatment (“hedge accounting”).

12. Slide 17-12 17 Net Investment Hedges: Reporting FX Gains & Losses l Report ALL FX gains and losses c urrently in OCI as they arise. l When the foreign sub is disposed of, transfer the OCI item to earnings (discussed in Chapter 18). n This is a special accounting treatment (“hedge accounting”).

13. Slide 17-13 17 FX Option Contracts: Definition of An FX Option lA contractual agreement whereby one party grants another party the right to: n Buy or sell a given quantity of currency. n At a specified exchange rate (for a fee). n During a specified future period.

14. Slide 17-14 17 FX Option Contracts: Terminology--Contracting Parties lThe two parties to an option contract are the writer and the holder (purchaser). l Writer’s perspective: A written option. l Holder’s perspective: A purchased option. &

15. Slide 17-15 17 FX Option Contracts: Any Company Can Be a Writer l The Typical Situation: n The writer is the FX trading department of an international bank. n The holder is an importer or exporter. l The Infrequent Situation: n The writer is a nonbank corporation. n The holder is a corporation.

16. Slide 17-16 17 FX Option Contracts: Terminology--Calls and Puts lThere are two kinds of options: n Call: An option to buy. n Put: An option to sell.

17. Slide 17-17 17 FX Option Contracts: Terminology--Exercise/Strike Prices l Exercise price means the same as strike price. =

18. Slide 17-18 17 FX Option Contracts: To Walk Away or Not Walk Away lThe holder can always “ walk away.” lThe writer can never walk away.

19. Slide 17-19 17 FX Option Contracts: Compared With Stock Options lIn an employee stock option : n The company is the writer. n The employee is the holder. n The employee can only have a gain. n The company cannot have a reportable loss --but will have less cash than it would have had if the stock had been issued at its current FV at the exercise date.

20. Slide 17-20 17 FX Options: One-Sided Exposure-- I Win & You Lose l The holder can ONLY GAIN (less premium paid). lThe writer can ONLY LOSE (less premium earned). lThe holder’s GAIN always equals the writer’s LOSS. l Both parties can break even (but usually do not).

21. Slide 17-21 17 FX Option Contracts: The Net Result l A Zero-Sum Game : $33,000 + $(33,000) = $ -0- n Holder’s GAIN = Writer’s LOSS HolderWriter NET

22. Slide 17-22 17 FX Option Contracts: Hopes & Dreams--The Holder’s Objective lThe option holder (purchaser) hopes to: n Buy low & sell high. Call Put Sell at.... $40 $40 Ex. Price Buy at..... 30 Ex. Price 30 GAIN.... $10 $10

23. Slide 17-23 17 FX Option Contracts: Hopes & Dreams--The Writer’s Objective lThe option writer hopes that: The holder “takes a walk ” (does not exercise the option).

24. Slide 17-24 17 FX Options: Premiums-- Paid on the “Front End” lThe option holder pays a premium to the option writer -- at the inception of the contract. lThe premium compensates the option writer for the exchange risk the writer will incur. lThe premium is the cost of buying insurance.

25. Slide 17-25 17 FX Options: Premiums- -To Be “ Amortized” Off of the Books lPremiums (always paid at the contract inception ) are capitalized as assets. lThis asset must be reduced to a zero value by the contract expiration date. lThus the option holder must AMORTIZE the premium off of its books over the life of the contract ( the opposite of the accruing process).

26. Slide 17-26 17 FX Options: Premiums--A “Time Value” Element l Premiums are called a time value element. l Typically, the time value element loses its value as a result of the passage of time.

27. Slide 17-27 17 FX Options: How to Subsequently Value the “Time Value” Element l Method #1: Adjust to its fair value ( obtainable from market quotes ). n FAS 133 requires this method. l Method #2: Amortize off of the books using the straight-line method. n Was allowed prior to FAS 133.

28. Slide 17-28 17 FX Options: The “Intrinsic Value” Element lA favorable change in the exchange rate creates intrinsic value --the option is “ in the money.”

29. Slide 17-29 17 FX Options: How to Subsequently Value the “Intrinsic Value” Element l Method #1: Adjust to its fair value ( obtainable from market quotes ). n FAS 133 requires this method. l Method #2: Determine by the change in the spot rate. n Allowed prior to FAS 133.

30. Slide 17-30 17 FX Options: Relative Importance of The Two Elements l The “ Intrinsic value” element is the elephant. l The “ time value” element is the elephant’s tail.

31. Slide 17-31 17 FX Options: Split Accounting--Defined l Split Accounting: Accounting for the “intrinsic value” element separately from the “time value” element. l Recall that the term “accounting” encompasses both : n How to value an asset or liability and n How to report that change in value (such as (1) in earnings, (2) in OCI, or (3) a deferred charge or deferred credit ).

32. Slide 17-32 17 FX Options: Split Accounting--Possibilities l Split Accounting Possibilities: Intrinsic Time Value Value VALUE the contract: The same way............ A A Differently............... A B REPORT the change in value : The same way............ X X Differently................ X Y

33. Slide 17-33 17 FX Options: Split Accounting-- Requirements of FAS 133 l Intrinsic Time Value Value Requires the identical manner of VALUING...... FV FV Requires identical REPORTING for “undesignated” hedges In In & “fair value” hedges...... Earnings Earnings Permits different REPORTING for “cash flow” hedges & or In In OCI “net investment” hedges.... OCI Earnings

34. Slide 17-34 17 FX Forwards: Noncancelable Contracts l Legal description: A contractual agreement to exchange currencies at: n A specified future date. n A specified exchange rate. l Substance: A noncancelable purchase order for a commodity --currency. l Nature: EXECUTORY-- BOTH parties execute at the settlement (delivery) date. 3/22/X5 $1.37

35. Slide 17-35 17 FX Forwards: Labeling the Parties To a Forward lEach party is referred to as a “ counterparty.” lUnder the two-options view, however, each party to a forward exchange contract is viewed as being BOTH a writer and a holder.

36. Slide 17-36 17 FX Forwards: Both Parties Must Execute (Deliver) l Each party must deliver a currency to the other party. l No “walking away” (as for FX options ). Walking

37. Slide 17-37 17 FX Forwards: Two-Sided Exposure-- I Win & You Lose--You Win & I Lose l Each counterparty can have a GAIN or a LOSS. lOne party’s GAIN equals the other party’s LOSS. n BOTH parties cannot have: s A GAIN at the same time. s A LOSS at the same time.

38. Slide 17-38 17 FX Forwards: The Net Result l A Zero-Sum Game : $33,000 + $(33,000) = $ -0- n Hedger’s GAIN = FX Dealer’s LOSS $(22,000) + $22,000 = $ -0- n Hedger’s LOSS = FX Dealer’s GAIN I. Hedging Party FX Dealer NET II. Hedging Party FX Dealer NET

39. Slide 17-39 17 FX Forwards: Whether to Buy or Sell To Hedge l “Try to remember...” : n Method #1 -- “Buy-Buy” and “Sell-Sell”: s If buying inventory, buy forward to hedge. s If selling inventory, sell forward to hedge.

40. Slide 17-40 17 FX Forwards: Whether to Buy or Sell To Hedge--The Long and Short of It l “Try to remember...” : n Method #2-- “Do the OPPOSITE” (used by FX traders). s If buying inventory (creates an FX Payable [a “short“ position] ) GO “LONG” s If selling inventory (creates an FX Receivable [a “long“ position] ) GO “SHORT”

41. Slide 17-41 17 FX Forwards: Better to Buy Low & Sell High Than Vice-Verse

42. Slide 17-42 17 FX Forwards: Premiums and Discounts--to Be Accrued lPremiums and discounts are paid at the tail-end of the contract-- the settlement date (also called the “ delivery” date ). l Each party ACCRUES --not amortizes-- the premium or discount onto the books over the contract life.

43. Slide 17-43 17 FX Forwards: Premiums & Discounts--Income or Expense? l Buying at a: Premium = Unfavorable = Dec rease Discount = Favorable = Increase l Selling at a: Premium = Favorable = Increase Discount = Unfavorable = Decrease Impact on Equity

44. Slide 17-44 17 FX Forwards: Premiums and Discounts--A “Time Value” Element l Premiums and discounts are a “ time value” element. l Typically, the time value element “decreases in value” as a result of the passage of time.

45. Slide 17-45 17 FX Forwards: How to Subsequently Value the “Time Value “ Element l Method #1: Adjust to its fair value. n FAS 133 requires this method. l Method #2: Accrue onto the books using the straight-line method. n Was allowed prior to FAS 133.

46. Slide 17-46 17 FX Forwards: The “Intrinsic Value” Element lA change in the exchange rate creates intrinsic value. n Favorable change = An Asset n Unfavorable change = A Liability

47. Slide 17-47 17 FX Forwards: How to Subsequently Value the “Intrinsic Value” Element l Method #1: Adjust to its fair value (using present value of future cash flows). n FAS 133 requires this method. l Method #2: Determine by the change in the spot rate. n Allowed prior to FAS 133.

48. Slide 17-48 17 FX Forwards: Relative Importance of The Two Elements l The “ Intrinsic value” element is the elephant. l The “ time value” element is the elephant’s tail.

49. Slide 17-49 17 FX Forwards: Split Accounting--Defined l Split Accounting: Accounting for the “intrinsic value” element separately from the “time value” element. l Recall that the term “accounting” encompasses both : n How to value an asset or liability and n How to report that change in value (such as (1) in earnings, (2) in OCI, or (3) a deferred charge or deferred credit ).

50. Slide 17-50 17 FX Forwards: Split Accounting--Possibilities l Split Accounting Possibilities: Intrinsic Time Value Value VALUE the contract: The same way............ A A Differently............... A B REPORT the change in value : The same way............ X X Differently................ X Y

51. Slide 17-51 17 FX Forwards: Split Accounting-- Requirements of FAS 133 Intrinsic Time Value Value Requires the identical manner of VALUING...... FV FV Requires identical REPORTING for “undesignated” hedges In In & “fair value” hedges...... Earnings Earnings Permits different REPORTING for “cash flow” hedges & In In OCI or “net investment” hedges.... OCI Earnings

52. Slide 17-52 17 FX Forwards: Speculating-- It’s Not for The Faint of Heart l A Noncounterbalancing Situation: n Either a gain or a loss occurs-- never an offsetting gain and loss.

53. Slide 17-53 17 FX Forwards: Speculating--Ignore the Spot Rate--Use the Forward Rate l Nonsplit accounting : n Adjust to the quoted forward rate -- for the remaining life of the contract-- at each financial reporting date (achieves current value accounting ).

54. Slide 17-54 17 FX Forwards: Crossing Over The Hedged Item’s Transaction Date l After the Transaction Date: n Recognize all FX Gains & Losses currently in earnings. l Before the Transaction Date: n Recognize all FX Gains & Losses currently in earnings. n Simultaneously recognize FX Gains & Losses on FX Commitments in earnings.

55. Slide 17-55 17 Derivatives in General l Derivative defined: n An executory contract (to be executed or performed later by both parties), the value of which depends on the changes in another measure of value (often referred to as the “underlying” item).

56. Slide 17-56 17 Derivatives in General: Types of Underlying Items lThe underlying items from which derivatives derive their value are: n Rates n Indexes n Financial instruments n Commodities Dow Jones, Standard & Poors 500 Oil French franc.......$.23 (4/1/X8 )

57. Slide 17-57 17 Derivatives in General: Valuation and Nature l Valuation: n Derivatives are valued in the balance sheet at each financial reporting date at market value. l Nature: n Derivatives can be characterized as a “ zero-sum game” because of their “what one party gains, the other party loses” nature.

58. Slide 17-58 17 Derivatives in General: Types of Risk l Three risks in derivatives: n #1: MARKET RISK s An asset could decrease in value. s A liability could increase in value. l Either way, equity goes down.

59. Slide 17-59 17 Derivatives in General: Market Risk lThe party to a derivative whose position can become negative has unlimited market risk. l Market risk encompasses BOTH: n “Balance-sheet risk” n “Off-balance-sheet risk”

60. Slide 17-60 17 Derivatives in General: Types of Risk l Three risks in derivatives: n #2: CREDIT RISK s Creditors have it. AMOUNT OWED

61. Slide 17-61 17 Derivatives in General: Types of Risk l Three risks in derivatives: n #3: LIQUIDITY RISK (“got CASH?”) s Debtors have it.

62. Slide 17-62 17 Relationship of Credit Risk and Liquidity Risk-- The Same Coin l Credit risk and liquidity risk are “opposite sides of the same coin.” lThe creditor can’t collect unless the debtor is LIQUID.

63. Slide 17-63 17 End of Chapter 17 l Time to Clear Things Up-- Any Questions?