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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.

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CHAPTER 14

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  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

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