Foreign Currency Transactions and Hedging Foreign Exchange Risk Chapter Seven Foreign Currency Transactions and Hedging Foreign Exchange Risk McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Foreign Exchange Rates 7-2 An Exchange Rate is the cost of one currency in terms of another. Rates published daily in the Wall Street Journal are as of 4:00pm Eastern time on the day prior to publication. The published rates are wholesale rates that banks use with each other – retail rates to consumers are higher. The difference between the rates at which a bank is willing to buy and sell currency is known as the “spread.” Rates change constantly!!

Foreign Exchange Rates 7-3 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.

Foreign Exchange - Forward Contracts 7-4 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 rate is $.0069 US in 30 days, we still have to pay $.0080 US and we lose $1,100!!

Foreign Exchange – Option Contracts 7-5 An options contract gives the holder the option of buying (or selling) 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!

Foreign Currency - Option Contracts 7-6 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.

Foreign Currency Transactions 7-7 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. How do we account for the changes in the value of the foreign currency?

Foreign Currency Transactions 7-8 GAAP requires a two-transaction perspective. Account for the original sale in US Dollars. Account for gains/losses from exchange rate fluctuations.

Hedging Foreign Exchange Risk 7-9 Companies will seek to reduce the risks associated with foreign currency fluctuations by hedging… This means they will give up a portion of the potential gains to offset the possible losses. A company enters into a potential transaction whose exposure is the opposite of the one that has the associated risk.

Hedging Foreign Exchange Risk 7-10 Two foreign currency derivatives that are often used to hedge foreign currency transactions Foreign currency forward contracts Foreign currency options

Accounting for Derivatives 7-11 The fair value of the derivative is recorded at the same time as the transaction to be hedged, based on: 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 (the company’s incremental borrowing rate).

Accounting for Hedges 7-12 As the Fair Value of a forward contract changes, gains or losses are recorded. The company hopes to recognize the gain or loss from the hedge in the same period as the opposing gain or loss on the risk being hedged

Accounting for Hedges 7-13 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

Any other hedging instrument is a Fair Value Hedge. Accounting for Hedges 7-14 Cash Flow Hedge A Cash Flow Hedge completely offsets the variability of a foreign currency receivable or payable. Fair Value Hedge Any other hedging instrument is a Fair Value Hedge.

Option values Derived from a function combining: 7-15 Derived from a function combining: The difference between current spot rate and strike price The difference between foreign and domestic interest rates The length of time to option expiration The potential volatility of changes in the spot rate

Using a Foreign Currency Option as a Hedge 7-16 Options are carried at fair value on the balance sheet. Option fair values are determined by examining the current quotes for similar options and breaking the fair value into two components: Intrinsic Value & Time Value

Hedge of a Foreign Currency Firm Commitment 7-17 Occurs when a company hedges a transaction that has yet to take place. Example Ruff Wood orders 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 gain/loss on the hedge is recognized currently in net income, as is the gain/loss on the firm commitment attributable to the hedged risk.

Hedge of a Forecasted Foreign Currency Denominated Transaction 7-18 Cash flow hedge accounting may be used for foreign currency derivatives associated with a forecasted foreign currency transaction The forecasted transaction must be probable, highly effective, and the hedging relationship must be properly documented. Gains and losses on the hedging instrument are recorded in Other Comprehensive Income until the date of the forecasted transaction.