Chapter 9 Advanced

Chapter 9 8e SM

Chapter 9

Foreign currency transactions and Hedging foreign exchange risk

Answers to Problems

1. C(Foreign exchange gain/loss on foreign currency transaction)

An import purchase causes a foreign currency payable to be carried on the books. If the foreign currency depreciates, the dollar value of the foreign currency payable decreases, yielding a foreign exchange gain.

2. D(Method of accounting for foreign currency transactions)

Current accounting standards require a two-transaction perspective, accrual approach.

3. B(Foreign exchange gain/loss on foreign currency transaction)

Foreign exchange gains related to foreign currency import purchases are treated as a component of income before income taxes. If there is no foreign exchange gain in operating income, then the purchase must have been denominated in U.S. dollars or there was no change in the value of the foreign currency from October 1 to December 1, 2013.

4. C(Calculate foreign exchange gain/loss on foreign currency transaction)

The dollar value of the LCU receivable has decreased from $110,000 at December 31, 2013 to $95,000 at February 15, 2014. This decrease of $15,000 should be reported as a foreign exchange loss in 2014.

5. D(Calculate foreign exchange gain/loss on foreign currency borrowing)

The increase in the dollar value of the euro note payable represents a foreign exchange loss. In this case a $25,000 loss would have been accrued in 2013 and a $10,000 loss will be reported in 2014.

6. D(Foreign exchange gain/loss on foreign currency transaction)

A foreign currency receivable will generate a foreign exchange gain when the foreign currency increases in dollar value. A foreign currency payable will generate a foreign exchange gain when the foreign currency decreases in dollar value. Hence, the correct combination is franc (increase) and peso (decrease).

7. D

(Calculate foreign exchange gain/loss)

The merchandise purchase results in a foreign exchange loss of $8,000, the difference between the U.S. dollar equivalent at the date of purchase and at the date of settlement.

The increase in the dollar equivalent of the notes principal results in a foreign exchange loss of $20,000.

The total foreign exchange loss is $28,000 ($8,000 + $20,000).8. D

(Forward contract cash flow hedge of foreign currency denominated asset/liability)

The Thai baht is selling at a premium (forward rate exceeds spot rate). The exporter will receive more dollars as a result of selling the baht forward than if the baht had been received and converted into dollars on April 1. Thus, the premium results in additional revenue for the exporter.

9. D

(Forward contract fair value hedge of foreign currency firm commitment)

The parts inventory will be recognized at the spot rate at the date of purchase (FC100,000 x $.23 = $23,000).

10. D(Determine the fair value of a forward contract)

The forward contract must be reported on the December 31, 2013 balance sheet as a liability. Barnum has locked-in to purchase ringgits at $0.042 per ringgit but could have locked-in to purchase ringgits at $0.037 per ringgit if it had waited until December 31 to enter into the forward contract. The forward contract must be reported at its fair value discounted for two months at 12% [($.042 $.037) x 1,000,000 = $5,000 x .9803 = $4,901.50].

11. C(Calculate foreign exchange gain/loss on foreign currency transaction)

The 10 million won receivable has changed in dollar value from $35,000 at 12/1/13 to $33,000 at 12/31/13. The won receivable will be written down by $2,000 and a foreign exchange loss will be reported in 2013 income.

12. B(Forward contract fair value hedge of foreign currency denominated asset/liability)

The nominal value of the forward contract on December 31, 2013 is a positive $2,000, the difference between the amount to be received from the forward contract actually entered into, $34,000 ($.0034 x 10 million), and the amount that could be received by entering into a forward contract on December 31, 2013 that matures on March 31, 2014, $32,000 ($.0032 x 10 million). The fair value of the forward contract is the present value of $2,000 discounted for three months ($2,000 x .9706 = $1,941.20). On December 31, 2013, MNC Corp. will recognize a $1,941.20 gain on the forward contract and a foreign exchange loss of $2,000 on the won receivable. The net impact on 2013 income is $58.80.

13. A(Forward contract cash flow hedge of forecasted foreign currency transaction)

The krona is selling at a premium in the forward market, causing Pimlico to pay more dollars to acquire kroner than if the kroner were purchased at the spot rate on March 1. Therefore, the premium results in an expense of $10,000 [($.12 $.10) x 500,000].

The Adjustment to Net Income is the amount accumulated in Accumulated Other Comprehensive Income (AOCI) as a result of recognizing the Premium Expense and the fair value of the forward contract. The journal entries would be as follows:

3/1no journal entries

6/1Premium Expense$10,000

AOCI

$10,000

AOCI$2,500

Forward Contract

$2,500

Foreign Currency$57,500

Forward Contract2,500

Cash

$60,000

AOCI$7,500

Adjustment to Net Income

$7,500

14. C(Option cash flow hedge of forecasted foreign currency transaction)

This is a cash flow hedge of a forecasted transaction. The original cost of the option is recognized as an Option Expense over the life of the option.

15-17.(Option fair value hedge of a foreign currency firm commitment) 15. B

16. D

The easiest way to solve problems 15 and 16 is to prepare journal entries for the option fair value hedge and the firm commitment. The journal entries are as follows:

9/1/13

Foreign Currency Option$2,000

Cash

$2,000

12/31/13

Foreign Currency Option$300

Gain on Foreign Currency Option

$300

Loss on Firm Commitment$980.30

Firm Commitment

$980.30

[($.79 $.80) x 100,000 = $1,000 x .9803 = $980.30]

Net impact on 2013 net income:

Gain on Foreign Currency Option$300.00

Loss on Firm Commitment

(980.30)

$(680.30)

3/1/14



$700

Loss on Firm Commitment$2,019.70

Firm Commitment

$2,019.70

[($.77 $.80) x 100,000 = $3,000 $980.30 = $2,019.70]

Foreign Currency (C$)$77,000

Sales

$77,000

Cash$80,000

Foreign Currency (C$)

$77,000

Foreign Currency Option

3,000

Firm Commitment$3,000


$3,000

15-17. (continued)


Gain on Foreign Currency Option$ 700.00

Loss on Firm Commitment

(2,019.70)

Sales

77,000.00


3,000.00

$78,680.30

17. BNet cash inflow with option ($80,000 $2,000)$78,000

Cash inflow without option (at spot rate of $.77) 77,000

Net increase in cash inflow

$ 1,000

18-20.(Forward contract fair value hedge of a foreign currency firm commitment)

The easiest way to solve problems 18 and 19 is to prepare journal entries for the forward contract fair value hedge of a firm commitment. The journal entries are as follows:

3/1 no journal entries

3/31Forward Contract$1,250

Gain on Forward Contract

$1,250

($1,250 $0)

Loss on Firm Commitment$1,250

Firm Commitment

$1,250

Net impact on first quarter net income is $0.

18-20. (continued)

4/30Loss on Forward Contract$250

Forward Contract

$250

[Fair value of Forward Contract is

($.120 $.118) x 500,000 = $1,000;

$1,000 $1,250 = $250]

Firm Commitment$250

Gain on Firm Commitment

$250

Foreign Currency (pesos)$59,000

Sales [500,000 pesos x $.118]

$59,000

Cash [500,000 x $.120]

$60,000

Foreign Currency (pesos)

$59,000

Forward Contract

1,000



$1,000

Net impact on second quarter net income is: Sales $59,000 Loss on Forward Contract $250 + Gain on Firm Commitment $250 + Adjustment to Net Income $1,000 = $60,000.

18. A

19. C

20. BCash inflow with forward contract [500,000 pesos x $.12]$60,000

Cash inflow without forward contract [500,000 pesos x $.118]59,000

Net increase in cash flow from forward contract$ 1,00021-22. (Option cash flow hedge of a forecasted foreign currency transaction)

The easiest way to solve problems 21 and 22 is to prepare journal entries for the option cash flow hedge of a forecasted transaction. The journal entries are as follows:

11/1/13


Cash

$1,500

12/31/13

Option Expense$400


$400

(The option has no intrinsic value at 12/31/13 so the entire change in fair value is due to a change in time value; $1,500 $1,100 = $400 decrease in time value. The decrease in time value of the option is recognized as an expense in net income.)

Option Expense decreases net income by $400.

2/1/14

Option Expense$1,100

Foreign Currency Option 900

Accumulated Other Comprehensive Income (AOCI)

$2,000

(Record expense for the decrease in time value of the

option; $1,100 $0 = $1,100; and write-up option to fair

value ($.40 $.41) x 200,000 = $2,000 $1,100 = $900.)

Foreign Currency (BRL) [200,000 x $.41]$82,000

Cash [200,000 x $.40]

$80,000


2,000

Parts Inventory (Cost-of-goods-sold)$82,000

Foreign Currency (BRL)

$82,000

Accumulated Other Comprehensive Income (AOCI)$2,000


$2,000

21-22. (continued)


Option Expense$ (1,100)

Cost-of-Goods-Sold(82,000)

Adjustment to Net Income 2,000

Decrease in Net Income$ (81,100)

21. B

22. C

23.(10 minutes) (Foreign currency payable -- import purchase) a. The decrease in the dollar value of the LCU payable from November 1 (60,000 x .345 = $20,700) to December 31 (60,000 x .333 = $19,980) is recorded as a $720 foreign exchange gain in 2013. b. The increase in the dollar value of the LCU payable from December 31 ($19,980) to January 15 (60,000 x .359 = $21,540) is recorded as a $1,560 foreign exchange loss in 2014.

24.(10 minutes) (Foreign currency receivable export sale) a. The ostra receivable decreases in dollar value from (50,000 x $1.05) $52,500 at December 20 to $51,000 (50,000 x $1.02) at December 31, resulting in a foreign exchange loss of $1,500 in 2013. b. The further decrease in dollar value of the ostra receivable from $51,000 at December 31 to $49,000 (50,000 x $.98) at January 10 results in an additional $2,000 foreign exchange loss in 2014.

25.(10 minutes) (Foreign currency receivable export sale)

9/15Accounts Receivable (FCU) [100,000 x $.40]$40,000

Sales

$40,000

9/30Accounts Receivable (FCU) $2,000

Foreign Exchange Gain

$2,000

[100,000 x ($.42 $.40)]10/15Foreign Exchange Loss $5,000

Accounts Receivable (FCU)

[100,000 x ($.37 $.42)]

$5,000

Cash$37,000


$37,000

26. (10 minutes) (Foreign currency payable -- import purchase)12/1/13Inventory $52,800

Accounts Payable (LCU) [60,000 x $.88]

$52,800

12/31/13Accounts Payable (LCU) [60,000 x ($.82 $.88)] $3,600


$3,600

1/28/14Foreign Exchange Loss$4,800

Accounts Payable (LCU) [60,000 x ($.90 $.82)]

$4,800

Accounts Payable (LCU)$54,000

Cash

$54,000

27.(15 minutes) (Determine U.S. dollar balance for foreign currency transactions)

Inventory and Cost of Goods Sold are reported at the spot rate at the date the inventory was purchased. Sales are reported at the spot rate at the date of sale. Accounts Receivable and Accounts Payable are reported at the spot rate at the balance sheet date. Cash is reported at the spot rate when collected and the spot rate when paid.

a.Inventory [50,000 pesos x 40% x $.17]$3,400

b.COGS [50,000 pesos x 60% x $.17]$5,100

c.Sales [45,000 pesos x $.18]$8,100

d.Accounts Receivable [45,000 40,000 = 5,000 pesos x $.21]$1,050

e.Accounts Payable [50,000 30,000 = 20,000 pesos x $.21]$4,200

f.Cash [(40,000 x $.19) (30,000 x $.20)]$1,600

28.(25 minutes) (Prepare journal entries for foreign currency transactions)2/1/13Equipment $17,600

Accounts Payable (L) [40,000 x $.44]

$17,600

4/1/13Accounts Payable (L)$17,600

Foreign Exchange Loss400

Cash [40,000 x $.45]

$18,000

6/1/13Inventory$14,100

Accounts Payable (L) [30,000 x $.47]

$14,100

8/1/13Accounts Receivable (L) [40,000 x $.48]$19,200

Sales

$19,200

Cost-of-Goods Sold$9,870

Inventory [$14,100 x 70%]

$9,870

10/1/13 Cash [30,000 x $.49]$14,700

Accounts Receivable (L) [$19,200 x 3/4]

$14,400


300

11/1/13Accounts Payable (L) [$14,100 x 2/3]$9,400

Foreign Exchange Loss [20,000 x ($.50 $.47)]600

Cash [20,000 x $.50]

$10,000

12/31/13Foreign Exchange Loss$500

Accounts Payable (L) [10,000 x ($.52 $.47)]

$500

Accounts Receivable (L) [10,000 x ($.52 $.48)]$400


$400

2/1/14Cash [10,000 x $.54]$5,400

Accounts Receivable (L) [10,000 x $.52]

$5,200


200

3/1/14Accounts Payable (L) [10,000 x $.52]$5,200

Foreign Exchange Loss300

Cash [10,000 x $.55]

$5,500

29.(20 minutes) (Determine income effect of foreign currency payable import purchase)

a.Benjamin, Inc. has a liability of AL 160,000. On the date that this liability was created (December 1, 2013), the liability had a dollar value of $70,400 (AL 160,000 x $.44). On December 31, 2013, the dollar value has risen to $76,800 (AL 160,000 x $.48). The increase in the dollar value of the liability creates a foreign exchange loss of $6,400 ($76,800 $70,400) in 2013.

By March 1, 2014, when the liability is paid, the dollar value has dropped to $72,000 (AL 160,000 x $.45) creating a foreign exchange gain of $4,800 ($72,000 $76,800) to be reported in 2014.

b.Benjamin, Inc. has a liability of AL 160,000. On the date that this liability was created (September 1, 2013), the liability had a dollar value of $73,600 (AL 160,000 x $.46). On December 1, 2013, when the liability is paid, the dollar value has decreased to $70,400 (AL 160,000 x $.44). The drop in the dollar value of the liability creates a foreign exchange gain of $3,200 ($70,400 $73,600) in 2013.

c.Benjamin, Inc. has a liability of AL 160,000. On the date that this liability was created (September 1, 2013), the liability had a dollar value of $73,600 (AL 160,000 x $.46). On December 31, 2013, the dollar value has risen to $76,800 (AL 160,000 x $.48). The increase in the dollar value of the liability creates a foreign exchange loss of $3,200 ($76,800 $73,600) in 2013.

By March 1, 2014, when the liability is paid, the dollar value has dropped to $72,000 (AL 160,000 x $.45) creating a foreign exchange gain of $4,800 ($72,000 $76,800) to be reported in 2014.

30.(30 minutes) (Foreign currency borrowing)

a.9/30/13Cash$100,000

Note payable (dudek) [1,000,000 x $.10]

$100,000

(To record the note and conversion of 1 million

dudeks into $ at the spot rate.)

12/31/13Interest Expense$525

Interest Payable (dudek)

$525

[1,000,000 x 2% x 3/12 = 5,000 dudeks x $.105 spot rate]

(To accrue interest for the period 9/30 12/31/13.)

Foreign Exchange Loss$5,000

Note Payable (dudek) [1 m x ($.105 $.10)]

$5,000

(To revalue the note payable at the spot rate of

$.105 and record a foreign exchange loss.)

9/30/14Interest Expense [15,000 dudeks x $.12]$1,800

Interest Payable (dudek)525

Foreign Exchange Loss [5,000 dudeks x

($.12 $.105)]75

Cash [20,000 dudeks x $.12]

$2,400

(To record the first annual interest payment,

record interest expense for the period 1/1 9/30/14,

and record a foreign exchange loss on the

interest payable accrued at 12/31/13.)

12/31/14Interest Expense$625

Interest Payable (dudek) [5,000 dudeks x $.125]

$625

(To accrue interest for the period 9/30 12/31/14.)

Foreign Exchange Loss$20,000

Note Payable (dudek) [1 m x ($.125 $.105)]

$20,000

(To revalue the note payable at the spot rate of

$.125 and record a foreign exchange loss.)

30. (continued)

9/30/15Interest Expense [15,000 dudeks x $.15]$2,250

Interest Payable (dudek)625

Foreign Exchange Loss [5,000 dudeks x

($.15 $.125)]125

Cash [20,000 dudeks x $.15]

$3,000

(To record the second annual interest payment,

record interest expense for the period 1/1 9/30/15,

and record a foreign exchange loss on the interest

payable accrued at 12/31/14.)

Note Payable (dudek)$125,000

Foreign Exchange Loss25,000

Cash [1 m dudeks x $.15]

$150,000

(To record payment of the 1 million dudek note.)

b.The effective cost of borrowing can be determined by considering the total interest expense and foreign exchange losses related to the loan and comparing this with the amount borrowed:

2013Interest expense

$525

Foreign exchange loss 5,000

Total

$5,525 / $100,000 = 5.525% for 3 months =

= 22.1% for 12 months


$2,425

Foreign exchange losses 20,075

Total

$22,500 / $100,000 = 22.5% for 12 months


$2,250

Foreign exchange losses 25,125Total

$27,375 / $100,000= 27.38% for 9 months



Because of appreciation in the value of the dudek, the effective annual borrowing costs range from 22.1% 36.5%.

30. (continued)

The net cash flow from this borrowing is:

Cash outflows:

Interest ($2,400 + $3,000) $5,400

Principal 150,000

$155,400

Cash inflow:

Borrowing(100,000)

Net cash outflow$ 55,400Ignoring compounding, this results in an effective borrowing cost of approximately 27.7% per year [$55,400 / $100,000 = 55.4% over two years / 2 years = 27.7% per year].

31. (40 minutes) (Forward contract hedge of foreign currency receivable)

a. Cash Flow Hedge

12/1/13Accounts Receivable (K) [20,000 x $2.00]$40,000

Sales

$40,000

No entry for the forward contract.

12/31/13Accounts Receivable (K) $2,000


$2,000

[20,000 x ($2.10-$2.00)]

AOCI$2,450.75

Forward Contract

$2,450.75

[20,000 x ($2.075 $2.20) = $2,500 x .9803 = $2,450.75]

Loss on Forward Contract$2,000

AOCI

$2,000

AOCI$500

Premium revenue

$500

[20,000 x ($2.075 $2.00) = $1,500 x 1/3 = $500]31. (continued)

Impact on 2013 income:

Sales

$40,000

Foreign Exchange Gain2,000

Loss on Forward Contract(2,000)

Premium Revenue 500Total

$40,500

3/1/14Accounts Receivable (K)$3,000


$3,000

[20,000 x ($2.25 $2.10)]

AOCI$1,049.25

Forward Contract

$1,049.25

[20,000 x ($2.25 $2.075) = $3,500 2,450.75] = $1,049.25

Loss on Forward Contract $3,000

AOCI

$3,000

AOCI$1,000

Premium revenue

$1,000

[$1,500 x 2/3 = $1,000]

Foreign Currency (K) [20,000 x $2.25] $45,000

Accounts Receivable (K)

$45,000

Cash [20,000 x $2.075] $41,500


Foreign Currency (K)

$45,000


Foreign Exchange Gain$3,000

Loss on Forward Contract(3,000)

Premium revenue

1,000Total

$1,000Impact on net income over both periods: $40,500 + $1,000 = $(41,500); equal to cash inflow.

31. (continued)

b. Fair Value Hedge

12/1/13Accounts Receivable (K) [20,000 x $2.00]$40,000

Sales

$40,000


12/31/13Accounts Receivable (K)$2,000


$2,000

[20,000 x ($2.10 $2.00)]

Loss on Forward Contract$2,450.75

Forward Contract

$2,450.75

[20,000 x ($2.075 $2.20) = $2,500 x .9803 = $2,450.75]Impact on 2013 income:

Sales

$40,000.00

Foreign Exchange Gain2,000.00

Loss on Forward Contract (2,450.75)

Total

$39,549.253/1/14Accounts Receivable (K)$3,000


$3,000

[20,000 x ($2.25 $2.10)]


Forward Contract

$1,049.25

[20,000 x (2.25 $2.075) = $3,500 2,450.75 = $1,049.25]

Foreign Currency (K) [20,000 x $2.25]$45,000

Accounts Receivable (K)

$45,000

Cash [20,000 x $2.075]$41,500



$45,000


Foreign Exchange Gain$3,000.00

Loss on Forward Contract(1,049.25)

Total

$1,950.75Impact on net income over both periods: $39,549.25 + $1,950.75 = $41,500; equal to cash inflow.

32. (40 minutes) (Forward contract hedge of foreign currency payable)

a.Cash Flow Hedge

12/1/13Parts Inventory (COGS)

$40,000

Accounts Payable (K)

$40,000

[20,000 x $2.00]


12/31/13Foreign Exchange Loss

$2,000


$2,000

[20,000 x ($2.10 $2.00)]

Forward Contract

$2,450.75

AOCI

$2,450.75

[20,000 x ($2.075 $2.20) = $2,500 x .9803 = $2,450.75]

AOCI

$2,000


$2,000

Premium Expense

$500

AOCI

$500

[20,000 x ($2.075 $2.00) = $1,500 x 1/3 = $500]


Parts inventory (COGS)$(40,000)

Foreign Exchange Loss(2,000)

Gain on Forward Contract2,000

Premium Expense (500)

Total$(40,500)

32.(continued)

3/1/14

Foreign Exchange Loss

$3,000


$3,000

[20,000 x ($2.25 $2.10)]

Forward Contract

$1,049.25

AOCI

$1,049.25

[20,000 x ($2.25 $2.075) = $3,500 2,450.75 = $1,049.25]

AOCI

$3,000


$3,000

Premium Expense

$1,000

AOCI

$1,000

[$1,500 x 2/3 = $1,000]

Foreign Currency (K) [20,000 x $2.25]

$45,000

Cash

$41,500

Forward Contract

3,500


$45,000


$45,000


Foreign Exchange Loss$(3,000)

Loss on Forward Contract3,000

Premium Expense (1,000)

Total$(1,000)

Impact on net income over both periods: $(40,500) + $(1,000) = $(41,500); equal to cash outflow.

32.(continued)

b. Fair Value Hedge

12/1/13Parts inventory (COGS)

$40,000


$40,000

[20,000 x $2.00]


12/31/13


$2,000


$2,000

[20,000 x ($2.10 $2.00)]

Forward Contract

$2,450.75


$2,450.75

[20,000 x ($2.075 $2.20) = $2,500 x .9803 = $2,450.75]


Parts inventory (COGS)$(40,000.00)

Foreign Exchange Loss(2,000.00)

Gain on Forward Contract 2,450.75Total$(39,549.25)

3/1/14


$3,000


$3,000

[20,000 x ($2.25 $2.10)]

Forward Contract

$1,049.25


$1,049.25

[20,000 x ($2.25 $2.075) = $3,500 2,450.75 = $1,049.25]

Foreign Currency (K) [20,000 x $2.25]

$45,000

Cash

$41,500

Forward Contract

3,500


$45,000


$45,000

32.(continued)


Foreign Exchange Loss$(3,000.00)

Gain on Forward Contract 1,049.25Total $(1,950.75)

Impact on net income over both periods: $(39,549.25) + $(1,950.75) = $(41,500.00); equal to cash outflow.

33. (30 minutes) (Option hedge of foreign currency receivable)

a.Cash Flow Hedge

6/1Accounts Receivable (P)$45,000

Sales [$.045 x 1,000,000 pesos]

$45,000


$2,000

Cash

$2,000



[($.048 $.045) x 1,000,000]

$3,000

AOCI$200


$200

[($.0018 $.0020) x 1,000,000]

Loss on Foreign Currency Option$3,000

AOCI

$3,000

Option Expense$200

AOCI

$200

DateFair ValueIntrinsic ValueTime ValueChange in Time Value6/1$2,000$0$2,000

6/30$1,800$0$1,800$ 200

9/1$1,000$1,000$0$1,800

33. (continued)

9/1 Foreign Exchange Loss$4,000

Accounts Receivable (P)

$4,000

[($.044 $.048) x 1,000,000]

AOCI$800


$800

[$1,800 $1,000]

AOCI$4,000


$4,000


AOCI

$1,800

(Change in time value of option is recognized as expense)

Foreign Currency (P)$44,000


$44,000

Cash$45,000

Foreign Currency (P)

$44,000


$1,000

Impact on Net Income over the Two Accounting Periods:

Sales$45,000

Foreign currency option expense (2,000)

Impact on net income $43,000 = Net cash inflow

b. Fair Value Hedge


Sales [$.045 x 1,000,000]

$45,000


Cash

$2,000



$3,000

[($.048 $.045) x 1,000,000]

Loss on Foreign Currency Option$200


$200

33. (continued)



$4,000

[($.044 $.048) x 1,000,000]



$800

Foreign Currency (P)$44,000


$44,000

Cash$45,000

Foreign Currency (P)

$44,000


$1,000

Impact on Net Income over the Two Accounting Periods:

Sales$45,000

Foreign Exchange Gain3,000

Foreign Exchange Loss (4,000)

Loss on Foreign Currency Option (1,000)

Impact on net income$43,000 =Net cash inflow

34. (30 minutes) (Option hedge of foreign currency payable)

a.Cash Flow Hedge

6/1Inventory [$.085 x 1,000,000]$85,000

Accounts Payable (M)

$85,000


Cash

$2,000

6/30Foreign Exchange Loss$3,000


$3,000

[($.088 .085) x 1,000,000]


AOCI

$2,000

[$4,000 $2,000]

AOCI$3,000


$3,000

Option Expense$1,000*

AOCI

$1,000

DateFair ValueIntrinsic ValueTime ValueChange in Time Value6/1$2,000$0$2,000 -

6/30$4,000$3,000$1,000-$1,000*

9/1$5,000$5,000$0-$1,000**

34. (continued)



$2,000

[($.09 $.088) x 1,000,000]


AOCI

$1,000

[$5,000 $4,000]

AOCI$2,000


$2,000

Option Expense$1,000**

AOCI

$1,000

Foreign Currency (M)$90,000

Cash

$85,000


$5,000

Accounts Payable (M)$90,000

Foreign Currency (M)

$90,000

Impact on net income:

Option Expense($2,000)34. (continued)

b. Fair Value Hedge

6/1Inventory$85,000


$85,000

[$.085 x 1,000,000]


Cash

$2,000



$3,000

[($.088 $.085) x 1,000,000]



$2,000

[$4,000 $2,000]9/1Foreign Exchange Loss$2,000


$2,000

[($.09 $.088) x 1,000,000]

Foreign Currency Option $1,000


$1,000

[$5,000 $4,000]

Foreign Currency (M)$90,000

Cash

$85,000


5,000

Accounts Payable (M)$90,000

Foreign Currency (M)

$90,000

Impact on net income:

Foreign Exchange Loss($5,000)

Gain on Foreign Currency Option 3,000

Impact on net income($2,000)

35.(30 minutes) (Forward contract cash flow hedge of foreign currency denominated asset)

Account Receivable (FCU) Forward

Forward Contract

SpotU.S. DollarChange in U.S.Rate to

Change in

DateRateValueDollar Value4/30/14Fair ValueFair Value

11/01/13$.53$53,000-$.52$0-

12/31/13$.50$50,000-$3,000$.48$3,8441+$3,844

4/30/14$.49$49,000-$1,000$.49$3,0002- $ 844

1 $52,000 $48,000 = $4,000 x .961 = $3,844; where .961 is the present value factor for four months at an annual interest rate of 12% (1% per month) calculated as 1/1.014.

2 $52,000 $49,000 = $3,000.

2013 Journal Entries11/01/13Accounts Receivable (FCU)$53,000

Sales

$53,000

There is no entry for the forward contract.

12/31/13Foreign Exchange Loss $3,000


$3,000

AOCI $3,000


$3,000

Forward Contract$3,844

AOCI

$3,844

Discount expense$333.33

AOCI

$333.33

[100,000 x ($.53 $.52) = $1,000 x 2/6 = $333.33]

The impact on net income for the year 2013 is:

Sales

$53,000.00

Foreign Exchange Loss(3,000.00)

Gain on Forward Contract 3,000.00Net Gain (Loss)

0.00

Discount Expense

(333.33)

Impact on net income$52,666.6735. (continued)

2014 Journal Entries

4/30/14Foreign Exchange Loss$1,000


$1,000

AOCI$1,000


$1,000

AOCI$844

Forward Contract

$844

Discount expense$666.67

AOCI

$666.67

Foreign Currency (FCU)$49,000


$49,000

Cash$52,000

Foreign Currency (FCU)

$49,000

Forward Contract

3,000


Foreign Exchange Loss$(1,000.00)

Gain on Forward Contract1,000.00Net Gain (Loss)

0.00

Discount Expense

(666.67)

Impact on net income

$(666.67)36.(30 minutes) (Forward contract fair value hedge of net foreign currency denominated asset)

Account Receivable (Payable) (mongs)Forward

Forward Contract

Change in U.S.Rate to

Change in

DateU.S. Dollar ValueDollar Value1/31/14Fair ValueFair Value

11/30/13$265,000 ($159,000)-$.52$0-

12/31/13$250,000 ($150,000)-$15,000 (-$9,000)$.48$7,9211+$7,921

1/31/14$245,000 ($147,000)-$ 5,000 (-$3,000)$.49$6,0002- $1,921

1 $104,000 $96,000 = $8,000 x .9901 = $7,921; where .9901 is the present value factor for one month at an annual interest rate of 12% (1% per month) calculated as 1/1.01.

2 $104,000 $98,000 = $6,000.


11/30Accounts Receivable (mongs) $265,000

Sales

$265,000

[$.53 x 500,000 mongs]

Inventory$159,000

Accounts Payable

$159,000

[$.53 x 300,000 mongs]

There is no formal entry for the forward contract.


Accounts Receivable (mongs)

$15,000

Accounts Payable (mongs)$9,000


$9,000



$7,921


Sales

$265,000

Net Foreign Exchange Loss$ (6,000)

Gain on Forward Contract 7,921Net Gain (Loss)

1,921Impact on net income

$266,921

36. (continued)




$5,000



$3,000

Loss on Forward Contract$1,921

Forward Contract

$1,921

Foreign Currency (mongs)$245,000


$245,000


Foreign Currency (mongs)

$147,000

Cash$104,000

Foreign Currency (mongs)

$98,000

Forward Contract

$6,000


Net Foreign Exchange Loss$(2,000)

Loss on Forward Contract (1,921)

Impact on net income$(3,921)

The net effect on the balance sheet is an increase in cash of $104,000 and an increase in inventory of $159,000 with a corresponding increase in retained earnings of $263,000 ($266,921 $3,921).

37.(40 minutes) (Forward contract fair value hedge foreign currency receivable and firm commitment (sale)) a. Foreign Currency Receivable10/01Accounts Receivable (LCU)$69,000

Sales (100,000 LCUs x $.69)

$69,000


12/31Accounts Receivable (LCU)$2,000


$2,000

[($.71 $.69) x 100,000]


Forward Contract

$8,910.90

[($.74 $.65) x 100,000 = $ 9,000 x .9901 = $ 8,910.90]

1/31Accounts Receivable (LCU)$1,000


$1,000

[($.72 $.71) x 100,000]

Forward Contract$ 1,910.90

Gain on Forward Contract$ 1,910.90

[($.72 $.65) x 100,000 = $ 7,000 loss 8,910.90 = $ 1,910.90 gain]

Foreign Currency (LCU)$72,000

Accounts Receivable (LCU)

$72,000

Cash$65,000


Foreign Currency (LCU)

$72,000

The impact on net income:

Sale$69,000.00

Foreign Exchange Gain3,000.00

Loss on Forward Contract(8,910.90)

Gain on Forward Contract 1,910.90

Impact on net income$65,000.00 = Cash Inflow

37. (continued)

b. Foreign Currency Firm Commitment (Sale)10/01There is no entry to record either the sales agreement or the forward contract as both are executory contracts.

12/31Loss on Forward Contract$8,910.90

Forward Contract

$8,910.90

Firm Commitment$8,910.90


$8,910.90

1/31Forward Contract$1,910.90


$1,910.90


Firm Commitment

$1,910.90

Foreign Currency (LCU)$72,000

Sales

$72,000

Cash$65,000


Foreign Currency (LCU)

$72,000

Adjustment to Net Income$7,000

Firm Commitment

$7,000

Impact on Net Income:

Sales

$72,000

Net Loss on Forward Contract(7,000)

Net Gain on Firm Commitment7,000

Adjustment to Net Income (7,000)

$65,000 = Cash Inflow

38. (30 minutes) (Forward contract fair value hedge of a foreign currency firm commitment (purchase))

ForwardForward Contract

Firm Commitment

Rate to

Change in

Change in

Date10/31Fair ValueFair ValueFair ValueFair Value

8/1$.30$0-$0

$0-

9/30$.325$4,950.501+ $4,950.50$(4,950.50)1 $4,950.50

10/31$.320 (spot)$4,0002 $ 950.50$(4,000)2+ $ 950.50

1 ($65,000 $60,000) = $5,000 x .9901 = $4,950.5; where .9901 is the present value factor for one month at an annual interest rate of 12% (1% per month) calculated as 1/1.01.

2 ($64,000 $60,000) = $4,000.

a. Journal entries

8/1There is no entry to record either the purchase agreement or the forward contract as both are executory contracts.



$4,950.50


Firm Commitment

$4,950.50

10/31Loss on Forward Contract$950.50

Forward Contract

$950.50

Firm Commitment$950.50


$950.50

Foreign Currency (rupees)$64,000

Cash

$60,000

Forward Contract

4,000

Inventories (Cost-of-Goods-Sold)$64,000

Foreign Currency (rupees)

$64,000



$4,000

b.Assuming the inventory is sold in the fourth quarter, the net impact on net income is negative $60,000:

Cost-of-Goods-Sold

$(64,000)


Net impact on net income$(60,000)

c. The net cash outflow is $60,000.

39. (30 minutes) (Option fair value hedge of a foreign currency firm commitment (sale))

Firm CommitmentOptionOption

Spot

Change inPremium

Change in

DateRateFair ValueFair Valuefor 9/1Fair ValueFair Value

6/1$1.00--$0.010$5,000-

6/30$0.99$(4,901.50)1 $ 4,901.50$0.016$8,000+ $3,000

9/1$0.97$(15,000)2 $10,098.50$0.030$15,000+ $7,000

1 $495,000 $500,000 = $(5,000) x .9803 = $(4,901.5), where .9803 is the present value factor for two months at an annual interest rate of 12% (1% per month) calculated as 1/1.012.

2 $485,000 $500,000 = $(15,000).

a. Journal Entries

6/1Foreign Currency Option$5,000

Cash

$5,000

There is no entry to record the sales agreement

because it is an executory contract.

6/30Loss on Firm Commitment$4,901.50

Firm Commitment

$4,901.50



$3,000

9/1Loss on Firm Commitment$10,098.50

Firm Commitment

$10,098.50



$7,000

Foreign Currency (lek)$485,000

Sales

$485,000

Cash$500,000

Foreign Currency (lek)

$485,000


15,000



$15,000

39. (continued)

b. Impact on Net Income

The impact on net income for the second quarter is:

Loss on Firm Commitment$(4,901.50)

Gain on Foreign Currency Option 3,000.00

Impact on net income

$(1,901.50)

The impact on net income for the third quarter is:

Sales

$485,000.00

Loss on Firm Commitment(10,098.50)

Gain on Foreign Currency option7,000.00Adjustment to Net Income 15,000.00Impact on net income

$496,901.50

The impact on net income over the second and third quarters is:

$495,000 ($496,901.50 $1,901.50)

c. Net Cash Inflow

The net cash inflow resulting from the sale is: $500,000 $5,000 = $495,000

40.(20 minutes) (Option fair value hedge of a foreign currency firm commitment (purchase))

Firm CommitmentOptionOption

Spot

Change inPremium

Change in


11/20$.20--$.008$400-

a) 12/20$.21$(500)1 $500$.0103$500+ $100

b) 12/20$.18$1,0002+ $1,000$.0004$0 $400

1 $10,000 $10,500 = $(500).

2 $10,000 $9,000 = $1,000.

3The premium on 12/20 for an option that expires on that date is equal to the options intrinsic value. Given the spot rate on 12/20 of $.21, a call option with a strike price of $.20 has an intrinsic value of $.01 per mark.

4The premium on 12/20 for an option that expires on that date is equal to the options intrinsic value. Given the spot rate on 12/20 of $.18, a call option with a strike price of $.20 has no intrinsic value the premium on 12/20 is $.000.

a.The option strike price ($.20) is less than the spot rate ($.21) on December 20, the date the parts are to be paid for. Therefore, Big Arber will exercise its option. The journal entries are as follows:

11/20Foreign Currency Option$400

Cash

$400

There is no entry to record the purchase agreement


12/20Loss on Firm Commitment$500

Firm Commitment

$500



$100

Foreign Currency (pijio)$10,500

Cash

$10,000


500

Parts inventory$10,500

Foreign Currency (pijio)

$10,500

The following entry is made in the period when the inventory affects net income through cost-of-goods-sold:

Firm Commitment$500


$500

40. (continued)b.The option strike price ($.20) is greater than the spot rate ($.18) on December 20, the date the parts are to be paid for. Therefore, Big Arber will allow the option to expire unexercised. Foreign currency will be acquired at the spot rate on December 20. The journal entries are as follows:

11/20Foreign Currency Option$400

Cash

$400

There is no entry to record the purchase agreement


12/20Firm Commitment$1,000


$1,000



$400

Foreign Currency (pijio)$9,000

Cash

$9,000

Parts Inventory$9,000

Foreign Currency (pijio)

$9,000


Adjustment to Net Income$1,000

Firm Commitment

$1,000

41.(20 minutes) (Option cash flow hedge of a forecasted transaction)

a.12/15/13Foreign Currency Option$5,000

Cash [1 million marks x $.005]

$5,000

No journal entry related to the forecasted

transaction.

12/31/13Foreign Currency Option$3,000

AOCI

$3,000

To recognize the increase in the value of

the foreign currency option with the counterpart

recorded in AOCI.


AOCI

$1,000

To recognize the decrease in the time value

of the option as expense.

[($.584 $.58) x 1,000,000 = $4,000 $3,000 = $1,000]

3/15/14Foreign Currency Option$2,000

AOCI

$2,000

To recognize the increase in the value of the

Foreign Currency Option with the counterpart

recorded in AOCI.


AOCI

$4,000

To recognize the decrease in the time value of

the option as expense.

Foreign Currency (marks)$590,000

Cash

$580,000


10,000

To record exercise of the foreign currency

option at the strike price of $.58 and close

out the foreign currency option account.

Parts Inventory$590,000

Foreign Currency (marks)

$590,000

To record the purchase of parts and payment

of 1 million marks to the supplier.

41. (continued)

AOCI$10,000


$10,000

To transfer the amount accumulated in AOCI

as an adjustment to net income in the period

in which the forecasted transaction occurs.

b. Impact on net income: 2013 Option Expense $(1,000)

2014 Cost-of-goods-sold$(590,000)

Option Expense(4,000)


$(584,000)

The impact on net income over the two periods is $(585,000).

c. Net cash outflow for parts: $585,000 = ($5,000 + $580,000)

42.(60 minutes) (Unhedged foreign currency transaction; forward contract and option hedge of foreign currency liability; forward contract and option hedge of foreign currency firm commitment (purchase))Part a. Foreign Currency Liability (Unhedged) 9/15Inventory$200,000

Accounts Payable (euro)

$200,000



$10,000



$10,000

Foreign Currency (euro)$220,000

Cash

$220,000

Accounts Payable (euro)$220,000

Foreign Currency (euro)

$220,000

42. (continued)Part b. Forward Contract Fair Value Hedge of a Foreign Currency Liability

Accounts Payable (C)

Forward

Forward Contract

Spot U.S. DollarChange in U.S.Rate to

Change in

DateRateValueDollar Value 10/31Fair ValueFair Value

9/15$1.00$200,000

-$1.06$0

-

9/30$1.05$210,000+$10,000$1.09$5,940.601+$5,940.60

10/31$1.10$220,000+$10,000$1.10$8,000.002+$2,059.40

1 $218,000 $212,000 = $6,000 x .9901 = $5,940.60; where .9901 is the present value factor for one month at an annual interest rate of 12% (1% per month) calculated as 1/1.01.

2 $220,000 $212,000 = $8,000.

9/15Inventory$200,000


$200,000




$10,000

Forward Contract$5,940.60


$5,940.60



$10,000

Forward Contract$2,059.40


$2,059.40


Cash

$212,000

Forward Contract

8,000



$220,000

42. (continued)Part c. Forward Contract Fair Value Hedge of a Foreign Currency Firm Commitment (Purchase)9/15There is no formal entry for the forward contract or the purchase order.



$5,940.60


Firm Commitment

$5,940.60



$2,059.40


Firm Commitment

$2,059.40


Cash

$212,000

Forward Contract

8,000

Inventory$220,000


$220,000


Firm Commitment $8,000


$8,000

42. (continued)Part d. Option Cash Flow Hedge of a Foreign Currency LiabilityThe following schedule summarizes the changes in the components of the fair value of the euro call option with a strike price of $1.00 for October 31.

Change

Change

SpotOptionFairin FairIntrinsicTimein Time

DateRatePremiumValueValueValueValueValue

09/15$1.00$.035$7,000-$0$7,0001-

09/30$1.05$.070$14,000+ $7,000 $10,0002$4,0002- $3,000

10/31$1.10$.100$20,000+ $6,000$20,000$03- $4,000

1 Because the strike price and spot rate are the same, the option has no intrinsic value. Fair value is attributable solely to the time value of the option.

2 With a spot rate of $1.05 and a strike price of $1.00, the option has an intrinsic value of $10,000. The remaining $4,000 of fair value is attributable to time value.

3 The time value of the option at maturity is zero.

9/15Inventory$200,000


$200,000


Cash

$7,000



$10,000


AOCI

$7,000

AOCI$10,000


$10,000


AOCI

$3,000

42. (continued)10/31 Foreign Exchange Loss$10,000


$10,000


AOCI

$6,000

AOCI$10,000


$10,000


AOCI

$4,000


Cash

$200,000


$20,000



$220,000

42. (continued)Part e. Option Fair Value Hedge of a Foreign Currency Firm Commitment (Purchase)

Firm CommitmentOptionForeign Currency Option

Spot

Change inPremium

Change in


9/15$1.00$0-$.035$ 7,000-

9/30$1.05$ (9,901)$ 9,9011$.070$14,000+$7,000

10/31$1.10$(20,000)$10,099$.100$20,000+$6,000

1 $210,000 $200,000 = $(10,000) x .9901 = $(9,901), where .9901 is the present value factor for one month at an annual interest rate of 12% (1% per month) calculated as 1/1.01.


Cash

$7,000



$7,000


Firm Commitment

$9,901



$6,000


Firm Commitment

$10,099


Cash

$200,000


20,000

Inventory$220,000


$220,000


Firm Commitment $20,000


$20,000

Chapter 9 Develop Your Skills

Research CaseInternational Flavors and Fragrances

The responses to this assignment might change over time as the company changes its use of foreign currency derivatives or changes the manner in which it discloses its foreign currency hedging activities in the annual report. The following responses are based on IFFs 2010 annual report.

1.In 2010, IFF provided information in the annual report related to its management of foreign exchange risk in the following locations:

a. Item 1A. Risk Factors. -- impact of currency fluctuation or devaluation

b. Item 7A. Quantitative and Qualitative Disclosures about Market Risk.

c. Note 14. Financial Instruments. derivatives

2. IFF uses foreign currency forward contracts to reduce exposure to cash flow volatility arising from foreign currency fluctuations associated with intercompany loans, certain foreign currency receivables and payables (hedges of foreign currency denominated assets and liabilities), and anticipated purchases of raw materials used in operations (hedges of forecasted transactions).

The company uses a Japanese Yen- U.S. Dollar swap to hedge monthly sale and purchase transactions between the U.S. and Japan.

The company also uses forward contracts to hedge net investments in foreign operations. (This topic is discussed in more detail in Chapter 10.)

3.In Item 7a., IFF indicates that the notional amount and maturity dates of such (i.e., forward) contracts match those of the underlying transactions. Toward the end of Note 14, the company also indicates that no ineffectiveness was experienced in the above noted cash flow hedges during the year ended December 31, 2010.Accounting Standards CaseForecasted TransactionsQuestions asked in the case are:

Is managements intent sufficient to assess that a forecasted transaction is likely to occur?

If not, what additional evidence must be considered?

Source of guidance: FASB ASC 815-20-55-24 Derivatives and Hedging; Hedging-General; Implementation Guidance and Illustrations; Probability of a Forecasted Transaction

ASC 815-20-55-24 states: An assessment of the likelihood that a forecasted transaction will take place should not be based solely on management's intent because intent is not verifiable. The transaction's probability should be supported by observable facts and the attendant circumstances. Consideration should be given to all of the following circumstances in assessing the likelihood that a transaction will occur.a.The frequency of similar past transactionsb.The financial and operational ability of the entity to carry out the transactionc.Substantial commitments of resources to a particular activity (for example, a manufacturing facility that can be used in the short run only to process a particular type of commodity)d.The extent of loss or disruption of operations that could result if the transaction does not occure.The likelihood that transactions with substantially different characteristics might be used to achieve the same business purpose (for example, an entity that intends to raise cash may have several ways of doing so, ranging from a short-term bank loan to a common stock offering).

The answers to the specific questions asked in the case are: Managements intent is not sufficient to assess whether a forecasted transaction is likely to occur.

Additional evidence listed in items a. e. in ASC 815-20-55-24 must be considered in assessing that likelihood. Excel CaseDetermine Foreign Exchange Gains and Losses

1., 2. and 3. Spreadsheet for the calculation of the foreign exchange gains (losses) related to Import/Export Companys foreign currency transactions for the year 2010.

Foreign CurrencyType of TransactionAmount in Foreign CurrencyTrans-action Date Exchange Rate at Transaction Date$ Value on Transaction DateSettle-ment DateExchange Rate at Settlement Date$ Value on Settlement DateForeign Exchange Gain (Loss)

Brazilian real (BRL)Import purchase (payable)(87,000)1/4/20100.577477(50,240.50)5/4/20100.57428(49,962.36)278.14

Swiss franc (CHF)Export sale (receivable)51,700 1/4/20100.96745550,017.42 5/4/20100.91371847,239.22 (2,778.20)

Swiss franc (CHF)Import purchase (payable)(55,000)5/4/20100.913718(50,254.49)10/4/20101.02836(56,559.80)(6,305.31)

EuroExport sale (receivable)37,200 4/1/20101.346850,100.96 9/1/20101.2847,616.00 (2,484.96)

EuroExport sale (receivable)37,200 4/1/20101.346850,100.96 10/1/20101.372651,060.72 959.76

Chinese yuan (CNY)Import purchase (payable)(342,000)1/4/20100.146471(50,093.08)10/4/20100.14945(51,111.90)(1,018.82)

South Korean won (KRW)Import purchase (payable)(55,600,000)1/4/20100.00086557(48,125.69)10/4/20100.0008892(49,439.52)(1,313.83)

Total Net Foreign Exchange Gain (Loss)(12,663.22)

Source of exchange rates: www.x-rates.com, Historical Lookup

Import/Export Company reported a net foreign exchange loss of $12,663.22 in 2010 income.

Possible discussion points for instructors: Note that all transactions had a $ value on transaction date of approximately $50,000. The size of the foreign exchange gains and losses reported in the last column differs substantially across transactions because of different rates and directions of change in the exchange rates across the currencies in which Import/Export Company had exposures. At one extreme, the large depreciation in value of the CHF from 1/4/10 to 5/4/10 coupled with an asset exposure resulted in a large foreign exchange loss. The large appreciation in value of the CHF from 5/4/10 to 10/4/10 coupled with the CHF liability exposure also generated a large foreign exchange loss. The depreciation in value of the Euro from 4/1/10 to 9/1/10 resulted in a foreign exchange loss on one of the companys Euro receivables; the overall appreciation in value of the Euro from 4/1/10 to 10/1/10 resulted in a foreign exchange gain on a second Euro receivable.

Analysis CaseCash Flow Hedge

1. Given the $6,000 total Premium Expense, the forward rate on 2/1/13 must have been $1.06 [($1.06 $1.00 spot) x 100,000 euros = $6,000].

2. Given that the forward contract is reported as a liability of $1,980 ($2,000 x .9901), the forward rate at 3/31/13 must have been $1.04 [($1.04 $1.06) x 100,000 euros = $2,000]. The fact that the forward contract is a liability signals that the forward rate at 3/31 is less than the forward rate on 2/1.

3. Given that the cost of goods sold is $103,000, the spot rate on 5/1/13 must have been $1.03. Linber must pay $1.06 per euro under the forward contract, so the forward contract results in an economic loss of $3,000 [($1.06 $1.03) x 100,00 euros]. The negative adjustment to net income reflects this economic loss.

4. The Premium Expense of $6,000 reflects the increase in cost for the parts from the date the transaction was forecasted until the date of purchase. If Linber had purchased 100,000 euros on 2/1/13 at the spot rate of $1.00, it could have saved $6,000.

Internet CaseHistorical Exchange Rates

1. Spreadsheets for the calculation of the foreign exchange gains (losses) related to Pier Ten Companys foreign currency account receivables.CurrencyCodeForeign Currency Account ReceivableExchange Rate on 12/14/10U.S. Dollar Value on 12/14/10

Indian rupeeINR 898,000 0.022215 $19,949.07

Philippine pesoPHP 874,000 0.022811 19,936.81

Japanese yenJPY 1,662,500 0.01197 19,900.13

Malaysian ringgitMYR 62,550 0.32 20,016.00

$79,802.01

CurrencyCodeForeign Currency Account ReceivableExchange Rate on 12/31/10U.S. Dollar Value on 12/31/10Foreign Exchange Gain (Loss) on 12/31/10

Indian rupeeINR 898,000 0.022371 $20,089.16 $ 140.09

Philippine pesoPHP 874,000 0.022925 20,036.45 99.64

Japanese yenJPY 1,662,500 0.012329 20,496.96 596.84

Malaysian ringgitMYR 62,550 0.324465 20,295.29 279.29

$80,917.86 $ 1,115.85

CurrencyCodeForeign Currency Account ReceivableExchange Rate on 1/14/11U.S. Dollar Value on 1/14/11Foreign Exchange Gain (Loss) on 1/14/11

Indian rupeeINR 898,000 0.022053 $19,803.59 $ (285.56)

Philippine pesoPHP 874,000 0.022596 19,748.90 (287.55)

Japanese yenJPY 1,662,500 0.012049 20,031.46 (465.50)

Malaysian ringgitMYR 62,550 0.326744 20,437.84 142.55

$80,021.80 $ (896.06)

CurrencyCodeForeign Currency Account ReceivableU.S. Dollar Value on 12/14/10U.S. Dollar Value on 1/14/11Net Foreign Exchange Gain (Loss)

Indian rupeeINR 898,000 $ 19,949.07 $19,803.59 $ (145.48)

Philippine pesoPHP 874,000 19,936.81 19,748.90 (187.91)

Japanese yenJPY 1,662,500 19,900.13 20,031.46 131.34

Malaysian ringgitMYR 62,550 20,016.00 20,437.84 421.84

$ 79,802.01 $80,021.80 $ 219.79

Source of exchange rates: www.x-rates.com, Historical Lookup, accessed December 12, 2012.

2. Pier Ten would have reported a net foreign exchange gain of $1,115.85 in 2010 and a net foreign exchange loss of $896.06 in 2011 related to these foreign currency receivables. The transactions denominated in Indian rupees and Philippine pesos resulted in a net foreign exchange loss of $145.48 and $187.91, respectively. The PHP receivable would have been the most important to hedge.

3. Assuming a strike price equal to the December 14, 2010 spot rate, the only foreign currency transactions for which the purchase of a put option costing $100 would have been beneficial are the transactions in Indian rupees and Philippine pesos. Net cash inflow from the INR receivable would have been $45.48 greater ($145.48 FX loss avoided less $100.00 cost of option) if a put option had been acquired and the net cash flow from the PHP receivable would have been $87.91 greater ($187.91 FX loss avoided less $100.00 cost of option) if a put option had been acquired. Put options in JPY and MYR would have had no value at 1/14/11. The purchase of JPY and MYR options would have resulted in a decrease in net cash inflow to Pier Ten of $200.00 (the cost of the options).

Communication CaseForward Contracts and Options

To:Mr. Dewey Nukem, CEO, Palmetto Bug Extermination Company (PBEC)

The primary advantage of using forward contracts to hedge foreign exchange risk is that there is no cost to enter into them. The disadvantage is that the company is obligated to exchange foreign currency for dollars at the contracted forward rate. Depending upon the future spot rate, this may or may not be advantageous for the company. In contrast, the primary disadvantage of using foreign currency options to hedge foreign exchange risk is that there is an up-front cost incurred to purchase them. The primary advantage is that the company is not required to exchange foreign currency for dollars at the option strike price if it is disadvantageous to do so. The company can simply allow the option to expire unexercised and the only cost is the initial premium that was paid to acquire the option.

Exporters sometimes use forward contracts to hedge export sales (import purchases) when the foreign currency is selling at a forward premium (discount) as this locks in premium revenue (discount revenue). The risk associated with this strategy is that the customer may or may not pay on time. If an exporter enters into a forward contract to sell foreign currency, and the customer does not pay on time, the exporter will need to purchase foreign currency at the spot rate to settle the forward contract. This is essentially the same as speculation; a gain or loss could arise. In this case, the exporter might be better off by purchasing a foreign currency put option. The exporter can simply allow the option to exercise if it has not received foreign currency from the customer by the expiration date.

Since PBEC is making import purchases, it has more control over the timing of when it will need foreign currency. In that case, it should be safe to enter into a forward contract to purchase foreign currency on the date when PBEC plans to pay for its purchases. However, there is always the risk that the supplier does not deliver on time, in which case the forward contract provides PBEC with foreign currency for which it has no current use.

The bottom line is that there is no right or wrong answer to the question which hedging instrument should be used to hedge the Swiss franc exposure to foreign exchange risk. Both forward contracts and option have the advantages and disadvantages.

Date post:	08-Mar-2016
Category:	Documents
Upload:	amanda
View:	223 times
Download:	0 times

Chapter 9 Advanced

Documents