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Chapter Seven

Chapter Seven. Foreign Currency Transactions and Hedging Foreign Exchange Risk. Foreign Exchange Markets. Each country uses its own currency for internal economic transactions. To make transactions in another country, units of that country’s currency must be acquired.

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Chapter Seven

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

  2. Foreign Exchange Markets • Each country uses its own currency for internal economic transactions. • To make transactions in another country, units of that country’s currency must be acquired. • The cost of those currencies is called the exchange rate.

  3. 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

  4. 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 • Remember – Rates change constantly during the day These are wholesale prices. Retail prices are higher.

  5. 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. ¥ = $?

  6. 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.

  7. Foreign Exchange Forward Contracts A forward contract requires the purchase 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 rateis $.0069 US in 30 days, we still have to pay $.0080 US and we lose $1,100!

  8. Foreign Exchange Options Contracts An options contract gives the holder the option of buying 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 $.00002 per ¥. That way, if the spot rate is $.0069 in 30 days, we only lose the $20 cost of the option contract!

  9. Foreign Currency Transactions • A U.S. company buys or sells goods or services to a party in another country. • 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?

  10. 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.

  11. Foreign Currency Transactions When a transaction occurs on one date (for example a credit sale) . . . . . . but the cash flow is at a later date . . . . . . fluctuating exchange rates can result in exchange rate gains or losses. ?

  12. 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” ?

  13. 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”

  14. Foreign Exchange Transaction Example On 12/1/04, 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 = .6425 £. Prepare BobCo’s journal entry.

  15. Foreign Exchange Transaction Example On 12/31/04, the exchange rate is $1 = .6400 £. At the balance sheet date we have to “remeasure”, or adjust, the original A/R to the current exchange rate.

  16. Foreign Exchange Transaction Example On 3/1/05, Coventry Corp. pays BobCo the 10,000 £ for the 12/1/04 sale. The exchange rate on 3/1/05, was $1 = .6500 £. On 3/1/05, we have to do TWO things. First, we have to “remeasure” the A/R.

  17. Foreign Exchange Transaction Example On 3/1/05, Coventry Corp. pays BobCo the 10,000 £ for the 12/1/04 sale. The exchange rate on 3/1/05, was $1 = .6500 £. On 3/1/05, we have to do TWO things. Second, we have record the receipt of the £.

  18. 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.

  19. Hedging Foreign Exchange Risk • To hedge a foreign currency transaction, companies use foreign currency derivatives • Two most common tools: • Foreign currency forward contracts • Foreign currency options

  20. 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 (Chapter 10). Unrecognized foreign currency firm commitments.

  21. 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. ?

  22. 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.

  23. Accounting for Hedges As the Fair Value of a forward contract changes, gains or losses are recorded. On 12/31/03, Bob has a forward contract to deliver 500,000¥ to Inuwashi Company on 1/31/04 at 120¥ = $1. The available 31-day forward rate on 12/31/03 is 122.50¥ = $1. Bob uses a discount rate of 6%. What is the value of the forward contract on 12/31/03 ?

  24. 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 to Comprehensive Income Gains/losses are recorded to the Income Statement

  25. Let’s try a Cash Flow Hedge Example

  26. Cash Flow Hedge - Date of Transaction Example On 4/1/04, MPG, Inc., a U.S. maker of auto parts, purchases parts from Aguila Company in Mexico 100,000 Pesoson credit. Payment is due in 180 days (October 8, 2004). The current exchange rate is $1 = 9.5000 pesos. Prepare MPG’s journal entry on 4/1/04.

  27. 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 9.7400 pesos = $1. This is an executory contract, so no entry is made on the contract date.

  28. Cash Flow Hedge - Interim Reporting Date Example At MPG’s year-end, 6/30/04, the value of the foreign currency payable must be re-measured, or adjusted, based on the 6/30/04 spot rate of $1 = 9.5250 pesos. • Remeasure the original payable:

  29. 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.

  30. Cash Flow Hedge - Interim Reporting Date Example Also, on 6/30/04, the forward contract must be recorded. The available forward rate to October 8, 2004 is $1 = 9.6200 pesos. MPG uses a 6% discount rate. • Record the forward contract:

  31. 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.

  32. Cash Flow Hedge - Date of Collection Example On 10/8/04, both the original receivable and the exchange contract come due. The 10/8/04 exchange rate is $1 = 9.4000 pesos. • Remeasure the Accounts Payable:

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

  34. Cash Flow Hedge - Date of Collection Example On 10/8/04, both the original payable and the exchange contract come due. The 10/8/04 exchange rate is $1 = 9.4000 pesos. . • Adjust the Forward Contract:

  35. 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.

  36. Cash Flow Hedge - Date of Collection Example On 10/8/04, both the original payable and the exchange contract come due. The 10/8/04 exchange rate is $1 = 9.4000 pesos. • Purchase the 100,000 pesos:

  37. Cash Flow Hedge - Date of Collection Example On 10/8/04, both the original payable and the exchange contract come due. The 10/8/04 exchange rate is $1 = 9.4000 pesos. • Complete the Forward Contract Payable:

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

  39. Fair Value Hedge - Date of Transaction Example On 12/1/04, Balloon Co., a U.S. balloon manufacturer sells balloons to Maison Rue., a french company, for 20,000 Euro’s (€) on credit. Payment is due in 90 days (March 1, 2005). The current exchange rate is $.9700 = 1 €. Prepare Balloon Co.’s journal entry.

  40. 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 12/1/04 of $.9500 = 1 €. This is an executory contract, so no entry is made on the contract date.

  41. Fair Value Hedge - Interim Reporting Date Example On 12/31/04, the value of the foreign currency receivable must be adjusted based on the 12/31/04 spot rate of $.9650 = 1 €. • Adjust the original receivable:

  42. Fair Value Hedge - Interim Reporting Date Example Also, on 12/31/04, the forward contract must be recorded. The available forward rate to March 1, 2005 is $.9520 = 1 €. Balloon uses a 6% discount rate. • Record the forward contract:

  43. Fair Value Hedge - Date of Collection Example On 3/1/05, both the original receivable and the forward contract come due. The 3/1/05 exchange rate is $.9540 = 1 €. • Adjust the Accounts Receivable:

  44. Fair Value Hedge - Date of Collection Example On 3/1/05, both the original receivable and the forward contract come due. The 3/1/05 exchange rate is $.9540 = 1 €. • Adjust the Forward Contract Payable:

  45. Fair Value Hedge - Date of Collection Example On 3/1/05, both the original receivable and the forward contract come due. The 3/1/05 exchange rate is $.9540 = 1 €. • Collect the 20,000 € in settlement of the Account Receivable:

  46. Fair Value Hedge - Date of Collection Example On 3/1/05, both the original receivable and the forward contract come due. The 3/1/05 exchange rate is $.9540 = 1 €. • Complete the Forward Contract:

  47. 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.

  48. 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.

  49. 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

  50. 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.

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