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EMBA Module 8. Foreign Currency Transactions and Hedging Foreign Exchange Risk. 7- 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.
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EMBA Module 8 Foreign Currency Transactions and Hedging Foreign Exchange Risk
7-2 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
7-3 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.
7-4 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.”
7-5 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.
7-6 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. ?¥ = $?
7-7 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.
7-8 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 rateis $.0069 US in 30 days, we still have to pay $.0080 US and we lose $1,100!!
7-9 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 $.00002 per ¥. That way, if the spot rate is $.0069 in 30 days, we only lose the $20 cost of the option contract!
7-10 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 by the option holder. (Remember: An option gives the holder “the right but not the obligation” to trade the foreign currency in the future.)
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 = Y120 90 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!
7-20 Foreign Currency Transactions The major accounting issue: How do we account for the changes in the value of the foreign currency? • 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.
7-21 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.
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. 7-22 Foreign Currency Transactions ?
7-23 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” ?
7-24 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”
7-25 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.
7-26 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.
7-27 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.
7-28 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 £.
7-29 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.
7-30 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.
7-31 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
7-32 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.
7-33 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. ?
7-34 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.
7-35 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 122.50¥ = $1. Chan uses a discount rate of 6%. What is the value of the forward contract on 12/31/08? ?
7-36 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
7-37 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 Pesoson credit. Payment is due in 180 days (October 8, 2008). The current exchange rate is $1 = 9.5000 pesos. Prepare Madh’s journal entry on 4/1/08.
7-38 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 9.7400 pesos = $1. This is an executory contract, so no entry is made on the contract date.
7-39 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 = 9.5250 pesos. • re-measure the original payable:
7-40 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.
7-41 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 = 9.6200 pesos. Madh uses a 6% discount rate. • Record the forward contract:
7-42 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.
7-43 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 = 9.4000 pesos. • re-measure the Accounts Payable:
7-44 Cash Flow Hedge - Date of Collection Example • As at year-end, Madh must record an entry to offset the foreign exchange loss of $139.
7-45 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 = 9.4000 pesos. . • Adjust the Forward Contract:
7-46 Cash Flow Hedge - Date of Collection Example • 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.
7-47 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 = 9.4000 pesos. • Purchase the 100,000 pesos:
7-48 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 = 9.4000 pesos. • Complete the Forward Contract Payable:
7-49 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.
7-50 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.