Foreign Currency Transactions and Hedging Foreign Exchange Risk Chapter 6 Foreign Currency Transactions and Hedging Foreign Exchange Risk

Foreign Currency Transactions and Hedging Foreign Exchange Risk Chapter Topics Foreign exchange market. Foreign exchange risk. Accounting for foreign currency transactions. Hedging. Foreign currency forward contracts and options. Accounting for hedges. Cash flow hedges and fair value hedges.

Foreign Currency Transactions and Hedging Foreign Exchange Risk Learning Objectives 1. Provide and overview of the foreign exchange market. 2. Explain how fluctuations in exchange rates give rise to foreign exchange risk. 3. Demonstrate the accounting for foreign currency transactions. 4. Describe how foreign currency forward contracts and foreign currency options can be used to hedge foreign exchange risk.

Foreign Currency Transactions and Hedging Foreign Exchange Risk Learning Objectives 5. Describe the concepts of cash flow hedges, fair value hedges, and hedge accounting. 6. Demonstrate the accounting for forward contracts and options used as cash flow hedges and fair value hedges to hedge foreign currency assets and liabilities, foreign currency firm commitments, and forecasted foreign currency transactions.

Foreign Exchange Markets Foreign exchange rate – purchase price of a foreign currency, e.g., in June 2005 it cost about 0.09 U.S. dollars (nine cents) to purchase one Mexican peso. From 1945 to 1973 countries had exchange rates fixed to the U.S. dollar. U.S. dollar was fixed to gold at $35 per ounce. Balance-of-payments deficits in the U.S. during the 1960s doomed this system in March 1973. Learning Objective 1

Foreign Exchange Markets Exchange Rate Mechanisms Independent float – currency value allowed to move freely with little government intervention. Pegged to another currency – currency value fixed (pegged) in terms of a particular foreign currency (e.g., U.S. dollar), central bank intervenes to maintain the exchange rate. European Monetary System (Euro) – twelve countries use a single currency. Learning Objective 1

Foreign Exchange Markets Foreign Exchange Rates Exchange rates, to the U.S. dollar, are published in many places on the internet and in newspapers. The Wall Street Journal publishes these daily, both as US$ equivalent (direct quotes) and currency per US$ (indirect quotes). For example, on March 16, 2005 the direct quote for a Euro was 1.3420 and the indirect quote was 0.7452 A direct quote is the reciprocal of an indirect quote and vice-versa. Learning Objective 1

Foreign Exchange Markets Spot rates and Forward rates Spot rate – today’s price for purchasing or selling a foreign currency. Forward rate – today’s price for purchasing or selling a foreign currency for some future date. Premium -- when the forward rate is greater than the spot rate for a particular day. Discount -- when the forward rate is less than the spot rate for a particular day. Learning Objective 1

Foreign Exchange Markets Option contracts Foreign currency option – gives the right, but not the obligation, to trade foreign currency for some period. Put option – the option to sell the foreign currency. Call option – the option to buy the foreign currency. Strike price – the exchange rate at which currency will be exchanged when option is exercised. Learning Objective 1

Foreign Exchange Markets Option contracts Option premium – cost of purchasing the option, is a function of the option’s intrinsic value and time value. Intrinsic value – is the gain that could be made by immediate exercise of the option. Time value – the value that derives from the fact that the currency value could increase during the remainder of the option period. Learning Objective 1

Exchange Rates and Foreign Exchange Risk Terminology Export sale – a company sells to a foreign customer and receives payment in the customer’s currency. Import purchase – a company purchases from a foreign supplier and pays in the supplier’s currency. Foreign exchange risk – the chance that the exporter will receive less, or the importer pay more, than anticipated as a result of change in exchange rate. Learning Objective 2

Exchange Rates and Foreign Exchange Risk Example Joe Inc., a U.S. company, makes a sale and ships goods to Jose, SA, a Mexican customer. Sales price is $100,000 (U.S.) and Joe allows Jose to pay in pesos in 30 days. The current exchange rate is $0.10 per 1 peso. Joe plans to receive 1,000,000 pesos ($100,000/$0.10). Learning Objective 2

Exchange Rates and Foreign Exchange Risk Joe has foreign exchange risk exposure because he may receive less than $100,000. Suppose the peso decreases such that in 30 days the exchange rate is $0.09 per 1 peso. Joe will receive 1,000,000 pesos which will be worth $90,000 (1,000,000 x $0.09), Joe receives $10,000 less due to exchange rate fluctuation. Learning Objective 2

Accounting for Foreign Currency Transactions Accounting – sale transaction One transaction perspective Treats sale and collection as one transaction. Transaction is complete when foreign currency is received and converted, sale is measured at converted amount. This approach is not allowed under IAS or U.S. GAAP. Learning Objective 3

Accounting for Foreign Currency Transactions Two transaction perspective Treats sale and collection as two transactions. Sale is one transaction, collection is second transaction. Sale is based on current exchange rate. If exchange rate changes, collection is for different amount. Difference is considered foreign exchange gain or loss. Concepts are identical for purchase transaction. Learning Objective 3

Accounting for Foreign Currency Transactions Transaction types, exposure type and gain or loss – export sales Export sale  asset exposure, if foreign currency appreciates  foreign exchange gain. Export sale  asset exposure, if foreign currency depreciates  foreign exchange loss. Learning Objective 3

Accounting for Foreign Currency Transactions Transaction types, exposure type and gain or loss – import purchases Import purchase  liability exposure, if foreign currency appreciates  foreign exchange loss. Import purchase  liability exposure, if foreign currency depreciates  foreign exchange gain. Learning Objective 3

Accounting for Foreign Currency Transactions Export sale – example 1 February 1, 2006, Joe Inc., a U.S. company, makes a sale and ships goods to Jose, SA, a Mexican customer. Sales price is $100,000 (U.S.). Jose agrees to pay in pesos on March 2, 2006. Spot rate as of February 1, 2006 is $0.10 per peso. Learning Objective 3

Accounting for Foreign Currency Transactions Export sale – example 1 Joe, Inc. records the sale (in U.S. $) on February 1, 2006 as follows: Accounts Receivable 100,000 Sales 100,000 Learning Objective 3

Accounting for Foreign Currency Transactions Export sale – example 1 On March 2, 2006, the spot rate is $0.09 per peso. Joe Inc. will receive 1,000,000 pesos, which are now worth $90,000. Joe makes the following journal entry: Cash 90,000 Foreign Exchange Loss 10,000 Accounts Receivable 100,000 Learning Objective 3

Accounting for Foreign Currency Transactions Export sale – example 2 Assume the following facts are added or change: Joe Inc., makes sale and ships goods on December 1, 2005 rather than February 1, 2006. Spot rate as of December 1, 2005 is $0.11 per peso. Spot rate as of December 31, 2005 is $0.105 per peso. Joe Inc. has a December 31 year end. Learning Objective 3

Accounting for Foreign Currency Transactions Export sale – example 2 Joe, Inc. records the sale (in U.S. $) on December 1, 2005 and the foreign exchange loss on December 31, 2005 as follows: Accounts Receivable 110,000 Sales 110,000 Foreign Exchange Loss 5,000 Accounts Receivable 5,000 Learning Objective 3

Accounting for Foreign Currency Transactions Export sale – example 2 Joe, Inc. records the receivable collection and an additional foreign exchange loss on March 2, 2006: Cash 90,000 Foreign Exchange Loss 15,000 Accounts Receivable 105,000 Learning Objective 3

Hedging Foreign Exchange Risk Hedging -- protecting against losses from exchange rate fluctuations. Companies often use foreign currency forward contracts and foreign currency options. Foreign currency forward contract – an agreement to buy or sell foreign currency at a future date. Foreign currency option – the right to buy or sell foreign currency for a period of time. Learning Objective 4

Hedging Foreign Exchange Risk Hedging risk on an export sale – example 1 Previously, Joe Inc. lost $20,000 without hedging as the peso fell from $0.11 to $0.09. The loss was ($0.11 - $0.09) x 1,000,000 pesos. Joe could have purchased a foreign currency forward contract on December 1, 2005. Learning Objective 4

Hedging Foreign Exchange Risk Hedging risk on an export sale – example 1 Under the contract, Joe would have agreed to sell 1,000,000 pesos for $0.105, on March 2, 2006. In this case, Joe would have collected $105,000 rather than $90,000. Instead of a $20,000 foreign exchange loss, Joe would have paid a $5,000 premium on the forward contract. Learning Objective 4

Hedging Foreign Exchange Risk Hedging risk on an export sale – example 2 Previously, Joe Inc. lost $20,000 without hedging as the peso fell from $0.11 to $0.09. The loss was ($0.11 - $0.09) x 1,000,000 pesos. Joe could have purchased a foreign currency option on December 1, 2005. The option premium is $4,000. Learning Objective 4

Hedging Foreign Exchange Risk Hedging risk on an export sale – example 2 Joe would now have the option sell 1,000,000 pesos for $0.11, on March 2, 2006. In this case Joe would have collected $110,000 rather than $90,000. Instead of a $20,000 foreign exchange loss, Joe would have paid $4,000 for the option. Learning Objective 4

Cash Flow Hedges, Fair Value Hedges, and Hedge Accounting Hedge accounting – an offsetting gain or loss from the hedge is recognized in net income during the same period as the gain or loss from the hedged item. Cash flow hedge – an accounting designation for hedges that offset variability in cash flows of hedged items. Fair value hedge – an accounting designation for hedges that offset the variability in fair value of hedged assets and liabilities. Learning Objective 5

Hedge accounting examples FC asset/forward contract/cash flow hedge. FC asset/forward contract/fair value hedge. FC asset/option/cash flow hedge. FC firm commitment/forward contract/fair value hedge. FC firm commitment/option/fair value hedge. Forecasted FC transaction/option/cash flow hedge. Learning Objective 6

Information for examples 1 and 2 Hedge Accounting Information for examples 1 and 2 December 1, 2006, Joe Inc., a U.S. company, makes a sale and ships goods to Jose, SA, a Mexican customer. Sales price is $110,000 (U.S.). Jose agrees to pay 1,000,000 pesos on March 2, 2006. Spot rates per peso are: December 1, 2005, $0.11, December 31, 2005, $0.10, and March 2, 2006, $0.095. The annual interest rate is 6% (0.5% per month). Learning Objective 6

Joe enters a foreign currency forward contract on December 1, 2005. Hedge Accounting Joe enters a foreign currency forward contract on December 1, 2005. The contract calls for Joe to sell 1,000,000 pesos at a forward rate of $0.105, on March 2, 2006. The forward rate on December 31, 2005 for March 2, 2006 delivery is $0.096. Learning Objective 6

Example 1, FC asset/forward/cash flow hedge Hedge Accounting Example 1, FC asset/forward/cash flow hedge 12/01/05 Accounts receivable 110,000 Sales 110,000 12/31/05 Foreign exchange loss 10,000 Accounts receivable 10,000 Accumulated Other Comprehensive Income 10,000 Gain on forward contract 10,000 Learning Objective 6

Example 1, FC asset/forward/cash flow hedge Hedge Accounting Example 1, FC asset/forward/cash flow hedge 12/31/05 Forward contract 8,911 Accumulated other comprehensive income 8,911 Discount expense* 1,667 Accumulated Other Comprehensive Income 1,667 (*discount expense is amortized using the straight-line method) Learning Objective 6

Example 1, FC asset/forward/cash flow hedge Hedge Accounting Example 1, FC asset/forward/cash flow hedge 3/02/06 Foreign exchange loss 5,000 Accounts receivable 5,000 Accumulated Other Comprehensive Income 5,000 Gain on forward contract 5,000 Forward contract 1,089 Accumulated Other Comprehensive Income 1,089 Learning Objective 6

Example 1, FC asset/forward/cash flow hedge Hedge Accounting Example 1, FC asset/forward/cash flow hedge 3/02/06 Discount expense 3,333 Accumulated Other Comprehensive Income 3,333 Foreign currency 95,000 Accounts receivable 95,000 Cash 105,000 Foreign currency 95,000 Forward contract 10,000 Learning Objective 6

Example 2, FC asset/forward/fair value hedge Hedge Accounting Example 2, FC asset/forward/fair value hedge 12/01/05 Accounts receivable 110,000 Sales 110,000 12/31/05 Foreign exchange loss 10,000 Accounts receivable 10,000 Forward contract 8,911 Gain on forward contract 8,911 Learning Objective 6

Example 2, FC asset/forward/fair value hedge Hedge Accounting Example 2, FC asset/forward/fair value hedge 3/02/06 Foreign exchange loss 5,000 Accounts receivable 5,000 Forward contract 1,089 Gain on forward contract 1,089 Learning Objective 6

Example 2, FC asset/forward/fair value hedge Hedge Accounting Example 2, FC asset/forward/fair value hedge 3/02/06 Foreign currency 95,000 Accounts receivable 95,000 Cash 105,000 Foreign currency 95,000 Forward contract 10,000 Learning Objective 6

Information for example 3 Hedge Accounting Information for example 3 December 1, 2006, Joe Inc., a U.S. company, makes a sale and ships goods to Jose, SA, a Mexican customer. Sales price is $110,000 (U.S.). Jose agrees to pay 1,000,000 pesos on March 2, 2006. Spot rates per peso are: December 1, 2005, $0.11, December 31, 2005, $0.10, and March 2, 2006, $0.095. Learning Objective 6

Hedge Accounting Joe purchases a foreign currency option for a premium of $4,000 ($0.004 x 1,000,000 pesos) on December 1, 2005. The market value of the option on December 31, 2005 is $3,000 ($0.003 x 1,000,000 pesos). The option allows Joe to sell 1,000,000 pesos at a strike price of $0.11, on March 2, 2006. Learning Objective 6

Example 3, FC asset/option/cash flow hedge Hedge Accounting Example 3, FC asset/option/cash flow hedge 12/01/05 Accounts receivable 110,000 Sales 110,000 Foreign currency option 4,000 Cash 4,000 12/31/05 Foreign exchange loss 10,000 Accounts receivable 10,000 Learning Objective 6

Example 3, FC asset/option/cash flow hedge Hedge Accounting Example 3, FC asset/option/cash flow hedge 12/31/05 Accumulated Other Comprehensive Income 10,000 Gain on foreign currency option 10,000 Accumulated Other Comprehensive Income 1,000 Foreign currency option 1,000 Option expense 1,000 Accumulated Other Comprehensive Income 1,000 Learning Objective 6

Example 3, FC asset/option/cash flow hedge Hedge Accounting Example 3, FC asset/option/cash flow hedge 3/02/06 Foreign exchange loss 5,000 Accounts receivable 5,000 Accumulated Other Comprehensive Income 5,000 Gain on foreign currency option 5,000 Foreign currency option 12,000 Accumulated Other Comprehensive Income 12,000 Learning Objective 6

Example 3, FC asset/option/cash flow hedge Hedge Accounting Example 3, FC asset/option/cash flow hedge 3/02/06 Option expense 3,000 Accumulated Other Comprehensive Income 3,000 Foreign currency 95,000 Accounts receivable 95,000 Cash 110,000 Foreign currency 95,000 Foreign currency option 15,000 Learning Objective 6

Information for example 4 Hedge Accounting Information for example 4 December 1, 2006, Joe Inc., a U.S. company, accepts an order deliver goods to Jose, SA, a Mexican customer on March 2, 2006. Sales price is $110,000 (U.S.). Jose agrees to pay 1,000,000 pesos upon delivery. Spot rates per peso are: December 1, 2005, $0.11, December 31, 2005, $0.10, and March 2, 2006, $0.095. The annual interest rate is 6% (0.5% per month). Learning Objective 6

Joe enters a foreign currency forward contract on December 1, 2005. Hedge Accounting Joe enters a foreign currency forward contract on December 1, 2005. The contract calls for Joe to sell 1,000,000 pesos at a forward rate of $0.105, on March 2, 2006. The forward rate on December 31, 2005 for March 2, 2006 delivery is $0.096. Joe chooses to measure the fair value of the firm commitment via reference to changes in the forward rate. Learning Objective 6

Example 4, FC firm commitment/forward/fair value hedge Hedge Accounting Example 4, FC firm commitment/forward/fair value hedge 12/01/05 No entry 12/31/05 Forward contract 8,911 Gain on forward contract 8,911 Loss on firm commitment 8,911 Firm commitment 8,911 Learning Objective 6

Example 4, FC firm commitment/forward/fair value hedge Hedge Accounting Example 4, FC firm commitment/forward/fair value hedge 3/02/06 Forward contract 1,089 Gain on forward contract 1,089 Loss on firm commitment 1,089 Firm commitment 1,089 Foreign currency 95,000 Sales 95,000 Learning Objective 6

Example 4, FC firm commitment/forward/fair value hedge Hedge Accounting Example 4, FC firm commitment/forward/fair value hedge 3/02/06 Cash 105,000 Foreign currency 95,000 Forward contract 10,000 Firm commitment 10,000 Adjustment to net income 10,000 Learning Objective 6

Information for example 5 Hedge Accounting Information for example 5 December 1, 2006, Joe Inc., a U.S. company, accepts an order deliver goods to Jose, SA, a Mexican customer on March 2, 2006. Sales price is $110,000 (U.S.). Jose agrees to pay 1,000,000 pesos upon delivery. Spot rates per peso are: December 1, 2005, $0.11, December 31, 2005, $0.10, and March 2, 2006, $0.095. Learning Objective 6

Hedge Accounting Joe purchases a foreign currency option for a premium of $4,000 ($0.004 x 1,000,000 pesos) on December 1, 2005. The time value of the option on December 31, 2005 is $3,000 ($0.003 x 1,000,000 pesos). The option allows Joe to sell 1,000,000 pesos at a strike price of $0.11, on March 2, 2006. Learning Objective 6

Example 5, FC firm commitment/option/fair value hedge Hedge Accounting Example 5, FC firm commitment/option/fair value hedge 12/01/05 Foreign currency option 4,000 Cash 4,000 12/31/05 Loss on firm commitment 9,901 Firm commitment 9,901 Foreign currency option 9,000 Gain on foreign currency option 9,000 Learning Objective 6

Example 5, FC firm commitment/option/fair value hedge Hedge Accounting Example 5, FC firm commitment/option/fair value hedge 3/02/06 Loss on firm commitment 5,099 Firm commitment 5,099 Foreign currency option 2,000 Gain on foreign currency option 2,000 Foreign currency 95,000 Sales 95,000 Learning Objective 6

Example 5, FC firm commitment/option/fair value hedge Hedge Accounting Example 5, FC firm commitment/option/fair value hedge 3/02/06 Cash 110,000 Foreign currency 95,000 Foreign currency option 15,000 Firm commitment 15,000 Adjustment to net income 15,000 Learning Objective 6

Information for example 6 Hedge Accounting Information for example 6 December 1, 2006, Joe Inc., a U.S. company, forecasts that it will deliver goods to Jose, SA, a Mexican customer on March 2, 2006. Sales price is $110,000 (U.S.). Jose agrees to pay 1,000,000 pesos upon delivery. Spot rates per peso are: December 1, 2005, $0.11, December 31, 2005, $0.10, and March 2, 2006, $0.095. Learning Objective 6

Hedge Accounting Joe purchases a foreign currency option for a premium of $4,000 ($0.004 x 1,000,000 pesos) on December 1, 2005. The time value of the option on December 31, 2005 is $3,000 ($0.003 x 1,000,000 pesos). The option allows Joe to sell 1,000,000 pesos at a strike price of $0.11, on March 2, 2006. Learning Objective 6

Example 6, Forecasted FC transaction/ option/cash flow hedge Hedge Accounting Example 6, Forecasted FC transaction/ option/cash flow hedge 12/01/05 Foreign currency option 4,000 Cash 4,000 12/31/05 Option expense 1,000 Foreign currency option 1,000 Learning Objective 6

Example 6, Forecasted FC transaction/ option/cash flow hedge Hedge Accounting Example 6, Forecasted FC transaction/ option/cash flow hedge 3/02/06 Foreign currency option 12,000 Option expense 3,000 Accumulated Other Comprehensive Income 15,000 Foreign currency 95,000 Sales 95,000 Learning Objective 6

Example 6, Forecasted FC transaction/ option/cash flow hedge Hedge Accounting Example 6, Forecasted FC transaction/ option/cash flow hedge 3/02/06 Cash 110,000 Foreign currency 95,000 Foreign currency option 15,000 Accumulated Other Comprehensive Income 15,000 Adjustment to net income 15,000 Learning Objective 6