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© The McGraw-Hill Companies, Inc., 2001
Slide 9-1
McGraw-Hill/Irwin
9
C H A P T E R
Foreign Currency Transactions and Hedging Foreign Exchange Risk
© The McGraw-Hill Companies, Inc., 2001
Slide 9-2
McGraw-Hill/Irwin
Foreign Exchange MarketsForeign 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.
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.
© The McGraw-Hill Companies, Inc., 2001
Slide 9-3
McGraw-Hill/Irwin
Exchange Rate MechanismsExchange Rate Mechanisms
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.
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.
© The McGraw-Hill Companies, Inc., 2001
Slide 9-4
McGraw-Hill/Irwin
Foreign Exchange MarketsForeign 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.¥ = $?
© The McGraw-Hill Companies, Inc., 2001
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McGraw-Hill/Irwin
?
Foreign Exchange MarketsForeign Exchange Markets
When a transaction occurs When a transaction occurs on one date (for example on one date (for example
a credit sale) . . .a credit sale) . . .
. . . but the cash flow is at a . . . but the cash flow is at a later date . . .later date . . .
. . . fluctuating exchange rates . . . fluctuating exchange rates can result in exchange rate can result in exchange rate
gains or losses.gains or losses.
© The McGraw-Hill Companies, Inc., 2001
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McGraw-Hill/Irwin
Foreign Exchange Transaction Example
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.
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.
© The McGraw-Hill Companies, Inc., 2001
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McGraw-Hill/Irwin
Foreign Exchange Transaction Example
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.
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.
© The McGraw-Hill Companies, Inc., 2001
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McGraw-Hill/Irwin
Foreign Exchange Transaction Example
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.
© The McGraw-Hill Companies, Inc., 2001
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McGraw-Hill/Irwin
Foreign Exchange RatesForeign 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.
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.
© The McGraw-Hill Companies, Inc., 2001
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McGraw-Hill/Irwin
This forward contract allows us to purchase 1,000,000 ¥ at a price
of $.0080 US in 30 days.
But if the spot rate is $.0069 US in 30
days, we still have to pay $.0080 US and
we lose $1,100!
Foreign Exchange Options Contracts
Foreign Exchange Options Contracts
A forward contract requires the purchase of currency units at a future date at the contracted
exchange rate.
A forward contract requires the purchase of currency units at a future date at the contracted
exchange rate.
© The McGraw-Hill Companies, Inc., 2001
Slide 9-11
McGraw-Hill/Irwin
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!
An options contract gives the holder the option of buying the currency units at a future date at the
contracted “strike” price.
An options contract gives the holder the option of buying the currency units at a future date at the
contracted “strike” price.
Foreign Exchange Options Contracts
Foreign Exchange Options Contracts
© The McGraw-Hill Companies, Inc., 2001
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HedgingHedging
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.
© The McGraw-Hill Companies, Inc., 2001
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McGraw-Hill/Irwin
Accounting for HedgesAccounting 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.
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.
?
© The McGraw-Hill Companies, Inc., 2001
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Accounting for HedgesAccounting for Hedges
As the Fair Value of a forward contract changes, gains or losses are recorded.
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?
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?
?
© The McGraw-Hill Companies, Inc., 2001
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Hedging - Date of TransactionExample
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.
© The McGraw-Hill Companies, Inc., 2001
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Hedging - Date of TransactionExample
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.
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.
This is an executory contract, so no entry is made on the contract
date.
© The McGraw-Hill Companies, Inc., 2001
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Hedging - Interim Reporting DateExample
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:
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:
© The McGraw-Hill Companies, Inc., 2001
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McGraw-Hill/Irwin
Hedging - Interim Reporting DateExample
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:
© The McGraw-Hill Companies, Inc., 2001
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McGraw-Hill/Irwin
Hedging - Date of CollectionExample
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:
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:
© The McGraw-Hill Companies, Inc., 2001
Slide 9-20
McGraw-Hill/Irwin
Hedging - Date of CollectionExample
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:
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:
© The McGraw-Hill Companies, Inc., 2001
Slide 9-21
McGraw-Hill/Irwin
Hedging - Date of CollectionExample
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:
© The McGraw-Hill Companies, Inc., 2001
Slide 9-22
McGraw-Hill/Irwin
Hedging - Date of CollectionExample
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:
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:
© The McGraw-Hill Companies, Inc., 2001
Slide 9-23
McGraw-Hill/Irwin
Using a Foreign Currency Option as a Hedge
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.
An option is a contract that allows you to exercise a predetermined exchange rate if it is to your advantage.
Options carry a cost.
© The McGraw-Hill Companies, Inc., 2001
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McGraw-Hill/Irwin
Accounting for a Foreign Currency Option Used as a Hedge
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.
© The McGraw-Hill Companies, Inc., 2001
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McGraw-Hill/Irwin
Accounting for a Foreign Currency Option Used as a Hedge
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.
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.
© The McGraw-Hill Companies, Inc., 2001
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McGraw-Hill/Irwin
Accounting for a Foreign Currency Option Used as a Hedge
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:
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:
© The McGraw-Hill Companies, Inc., 2001
Slide 9-27
McGraw-Hill/Irwin
Accounting for a Foreign Currency Option Used as a Hedge
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:
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:
© The McGraw-Hill Companies, Inc., 2001
Slide 9-28
McGraw-Hill/Irwin
Accounting for a Foreign Currency Option Used as a Hedge
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.
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.
© The McGraw-Hill Companies, Inc., 2001
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Accounting for a Foreign Currency Option Used as a Hedge
Accounting for a Foreign Currency Option Used as a Hedge
Note: exercising the option would have cost $10,750, so Jumbo chose to ignore it.
Note: exercising the option would have cost $10,750, so Jumbo chose to ignore it.
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.
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.
© The McGraw-Hill Companies, Inc., 2001
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McGraw-Hill/Irwin
Accounting for a Foreign Currency Option Used as a Hedge
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.
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.
© The McGraw-Hill Companies, Inc., 2001
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Accounting for a Foreign Currency Option Used as a Hedge
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.
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.
© The McGraw-Hill Companies, Inc., 2001
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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.
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.
Hedge of a Future Foreign Currency Commitment
Hedge of a Future Foreign Currency Commitment
Occurs when a company hedges a transaction that has yet to take place.
Occurs when a company hedges a transaction that has yet to take place.
ExampleRuff 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.
ExampleRuff 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.
© The McGraw-Hill Companies, Inc., 2001
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The End . . .
. . . sort of