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C H A P T E R

C H A P T E R. 9. 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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C H A P T E R

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  1. C H A P T E R 9 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 Markets As the relative strength of a country’s economy changes . . . . . . the exchange rate of the local currency relative to other currencies also fluctuates. ¥ = $?

  5. Foreign Exchange Markets 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.

  6. Foreign Exchange Transaction Example On 12/1/99, 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 = .6093 £. Prepare BobCo’s journal entry.

  7. Foreign Exchange Transaction Example On 3/1/00, Coventry Corp. pays BobCo the 10,000 £ for the 12/1/99 sale. The exchange rate on 3/1/00, was $1 = .6115 £. First, adjust the original A/R to the current exchange rate.

  8. Foreign Exchange Transaction Example On 3/1/00, Coventry Corp. pays BobCo the 10,000 £ for the 12/1/99 sale. The exchange rate on 3/1/00, was $1 = .6115 £. Second, record BobCo’s receipt of Coventry’s payment.

  9. 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.

  10. Foreign Exchange Options 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!

  11. 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!

  12. Hedging To control for the risk of exchange rate fluctuation, a forward contract for currency can be purchased. Hedging effectively eliminates the gain or loss exposure.

  13. Accounting for Hedges • 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. ?

  14. 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 5,000 £ to Lord Ashton on 1/31/04 at .625 £ = $1. The 12/31 30-day forward rate is .500 £ = $1. What is the gain or loss on the forward contract for Bob? ?

  15. Hedging - Date of TransactionExample On 12/1/99, Balloon Co., a U.S. balloon manufacturer sells balloons to Maison Rue., a french company, for 10,200 french francs on credit. Payment is due in 90 days. The current exchange rate is $1 = 4.800 FF. Prepare Balloon Co.’s journal entry.

  16. Hedging - Date of TransactionExample Balloon Co buys a 90-day forward contract to sell 10,200 FF at the 90-day forward rate on 12/1/99 of $1.00 = 5.000 FF. This is an executory contract, so no entry is made on the contract date.

  17. Hedging - Interim Reporting DateExample On 12/31/99, the value of the foreign currency receivable must be adjusted based on the 12/31/99 spot rate of $1.00 = 5.258 FF. • Adjust the original receivable:

  18. Hedging - Interim Reporting DateExample Also, on 12/31/99, the forward contract payable and gains/losses must be recorded. The 60-day forward rate at 12/31/99 is $1 = 5.100 FF. • Record the gain/loss on the forward contract payable:

  19. Hedging - Date of CollectionExample On 3/1/00, both the original receivable and the exchange contract come due. The 3/1/00 exchange rate is $1.00 = 5.400 FF. • Adjust the Accounts Receivable:

  20. Hedging - Date of CollectionExample On 3/1/00, both the original receivable and the exchange contract come due. The 3/1/00 exchange rate is $1.00 = 5.400 FF. • Adjust the Forward Contract Payable:

  21. Hedging - Date of CollectionExample On 3/1/00, both the original receivable and the exchange contract come due. The 3/1/00 exchange rate is $1.00 = 5.400 FF. • Collect the 10,000 FF in settlement of the Account Receivable:

  22. Hedging - Date of CollectionExample On 3/1/00, both the original receivable and the exchange contract come due. The 3/1/00 exchange rate is $1.00 = 5.400 FF. • Complete the Forward Contract Payable:

  23. 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.

  24. Accounting for a Foreign Currency Option Used as a Hedge On 6/15/02, Jumbo Co., a U.S. company, bought inventory from MexTech a Mexican seller. Jumbo agreed to pay MexTech 100,000 pesos in 30 days. The current exchange rate is $.1050 = 1 peso. Prepare Jumbo’s journal entry.

  25. Accounting for a Foreign Currency Option Used as a Hedge On 6/15, Jumbo bought an option contract to buy 100,000 pesos at the 30-day forward rate of $.1075 = 1 peso. The contract cost $.002 per peso.

  26. Accounting for a Foreign Currency Option Used as a Hedge On 6/30/02 (Jumbo’s year-end), the spot rate was $.1060. The option was valued was put at $250. • Adjust the original receivable:

  27. Accounting for a Foreign Currency Option Used as a Hedge On 6/30/02 (Jumbo’s year-end), the spot rate was $.1060. The option was valued was put at $250. • Adjust the value of the option:

  28. Accounting for a Foreign Currency Option Used as a Hedge On 7/15/02, the spot rate was $.1070. The option was not exercised, so it was allowed to expire (implied value = $0). • Adjust the value of the payable.

  29. Accounting for a Foreign Currency Option Used as a Hedge On 7/15/02, the spot rate was $.1070. The option was not exercised, so it was allowed to expire (implied value = $0). • Buy pesos at the spot rate. Note: exercising the option would have cost $10,750, so Jumbo chose to ignore it.

  30. Accounting for a Foreign Currency Option Used as a Hedge On 7/15/02, the spot rate was $.1070. The option was not exercised, so it was allowed to expire (implied value = $0). • Pay the A/P using the pesos.

  31. Accounting for a Foreign Currency Option Used as a Hedge Since the option was not exercised, and it was allowed to expire (implied value = $0), Jumbo must write it off as a loss. • Write off the Option.

  32. Hedge of a Future Foreign Currency Commitment Occurs when a company hedges a transaction that has yet to take place. Example Ruff Wood orders a 1,000,000 board feet of lumber from Brazil. Ruff Wood enters the hedge contract on the same day as the order is placed. Hedge accounting is only allowed under 2 conditions: 1. There is formal documentation of the hedge. 2. The hedge is expected to be highly effective.

  33. The End . . . . . . sort of

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