1 / 63

CHAPTER 14

CHAPTER 14. USING DERIVATIVES TO MANAGE FOREIGN CURRENCY EXPOSURES. Focus of Chapter 14. Types of Foreign Exchange (FX) Exposure The Concept and Technique of Hedging Using FX Options to Hedge Using FX Forwards to Hedge Derivative Financial Instruments — In General.

barb
Download Presentation

CHAPTER 14

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. CHAPTER 14 USING DERIVATIVES TO MANAGE FOREIGN CURRENCY EXPOSURES

  2. Focus of Chapter 14 • Types of Foreign Exchange (FX) Exposure • The Concept and Technique of Hedging • Using FX Options to Hedge • Using FX Forwards to Hedge • Derivative Financial Instruments— In General

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

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

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

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

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

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

  9. Undesignated Hedges:Reporting FX Gains & Losses • Report ALL FX gains and losses currently in earningsas they arise. • Thus no special accounting treatment (i.e., no “hedge accounting”).

  10. Fair Value Hedges:Reporting FX Gains & Losses • Report ALL FX gains and losses currently in earningsas they arise. • Simultaneously, recognize in earnings an FX loss or gain on the hedged item. • This is a special accounting treatment (“hedge accounting”).

  11. Cash Flow Hedges:Reporting FX Gains & Losses • Report ALL FX gains and losses currently in OCIas they arise. • When the hedged item is recorded in earnings, transfer the OCI item to earnings. • This is a special accounting treatment (“hedge accounting”).

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

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

  14. FX Option Contracts: Terminology—Contracting Parties • The two parties to an option contract are the writer and the holder (purchaser). • Writer’s perspective: A written option. • Holder’s perspective: A purchased option.

  15. FX Option Contracts: AnyCompany Can Be a Writer • The Typical Situation: • The writer is the FX trading department of an international bank. • The holder is an importer or exporter. • The Infrequent Situation: • The writer is a nonbank corporation. • The holder is a corporation.

  16. FX Option Contracts: Terminology—Calls and Puts • There are two kinds of options: • Call: An option to buy. • Put: An option to sell.

  17. FX Option Contracts: Terminology—Exercise/Strike Prices • Exercise price means the same as strike price.

  18. FX Option Contracts: To Walk Away or Not Walk Away • The holder can always “walk away.” • The writer can never walk away.

  19. FX Option Contracts: Compared With Stock Options • In an employeestockoption: • The company is the writer. • The employee is the holder. • The employee can only have a gain. • The companycannot 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. FX Options: One-Sided Exposure—I Win & You Lose • The holder can ONLY GAIN (less premium paid). • The writer can ONLY LOSE (less premium earned). • The holder’sGAIN always equals the writer’sLOSS. • Both parties can break even (but usually do not).

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

  22. FX Option Contracts: Hopes & Dreams—The Holder’s Objective • The option holder (purchaser) hopes to: • Buy low & sell high. CallPut Sellat .... $40 $40 Ex. Price Buyat..... 30 Ex. Price 30 GAIN.... $10 $10

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

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

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

  26. FX Options:Premiums—A “Time Value”Element • Premiums are called a time valueelement. • Typically, the time value element loses its value as a result of the passage of time.

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

  28. FX Options:The “Intrinsic Value” Element • A favorable change in the exchange rate creates intrinsic value—the option is “in the money.”

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

  30. FX Options: Relative Importanceof The Two Elements • The “Intrinsic value” element is the elephant. • The “time value” element is the elephant’s tail.

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

  32. FX Options:Split Accounting—Possibilities Split Accounting Possibilities: VALUE the contract: The same way. . . . . . . . . . . . A A Differently. . . . . . . . . . . . . . . A BREPORT the change in value : The same way . . . . . . . . . . . . X X Differently. . . . . . . . . . . . . . . . X Y Intrinsic Value Time Value

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

  34. FX Forwards:Noncancelable Contracts • Legal description: A contractual agreement to exchange currencies at: • A specified future date. • A specified exchange rate. • Substance: A noncancelable purchase order for a commodity—currency. • Nature: EXECUTORY—BOTHparties execute at the settlement (delivery) date. 3/22/X6 $1.37

  35. FX Forwards:Labeling the Parties To a Forward • Each party is referred to as a “counterparty.” • Under the two-options view, however, each party to a forward exchange contract is viewed as being BOTH a writerand a holder.

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

  37. FX Forwards: Two-Sided Exposure—I Win & You Lose—You Win & I Lose • Each counterparty can have a GAINor a LOSS. • One party’s GAINequals the other party’s LOSS. • BOTH parties cannot have: • A GAIN at the same time. • A LOSS at the same time.

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

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

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

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

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

  43. Impact on Equity FX Forwards: Premiums & Discounts—Income or Expense? • Buying at a:Premium= Unfavorable =DecreaseDiscount= Favorable =Increase • Selling at a:Premium= Favorable =IncreaseDiscount= Unfavorable =Decrease

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

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

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

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

  48. FX Forwards: Relative Importanceof The Two Elements • The “Intrinsic value” element is the elephant. • The “time value” element is the elephant’s tail.

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

  50. FX Forwards:Split Accounting—Possibilities • Split Accounting Possibilities: IntrinsicTime Value ValueVALUE the contract: The same way. . . . . . . . . . . . A A Differently. . . . . . . . . . . . . . . A BREPORT the change in value : The same way . . . . . . . . . . . . X X Differently. . . . . . . . . . . . . . . . X Y

More Related