Accounting 6570 Chapter 6 –Foreign Currency Transactions and Hedging Foreign Exchange Risk

Foreign Exchange Markets Foreign exchange rate Purchase price of a foreign currency-- e.g., in December 2007 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, so, by March 1973 most currencies were allowed to float in value.

Foreign Exchange Terms –Spot rates – current exchange rate –Direct quote (U.S. $ equivalent) –Indirect quote (Currency per U.S. $) For example, on February 15, 2008 the direct quote for a Euro was $ and the indirect quote was $ As a point of comparison, the direct quote when the Euro first appeared in 1998 was approximately $1.17 and the indirect quote was approximately $0.85. A direct quote is the reciprocal of an indirect quote and vice-versa. Forward rates – future exchange rate –Spread: difference in forward and spot –Premium: forward > spot –Discount: forward < spot

Foreign Currency Transactions Transaction denominated in a currency other than the reporting currency of a firm. In U.S., any currency other than the $U.S. dollar. Accounting Approaches: –Two transactions, recognize gains and losses –Two transactions, defer gains and losses –One transaction, recognize gains and losses

Two Transactions, Recognize Gains and Losses Example: Purchase equipment on account. Two transactions: –1) Purchase equipment –2) Pay off account payable. Gains and losses are recognized each income statement date until the account payable is paid off.

Two Transactions, Defer Gains and Losses Example: Purchase equipment on account. Two transactions: –1) Purchase equipment –2) Pay off account payable. Gains and losses are deferred until the account payable is paid off.

One transaction, recognize gains and losses Example: Purchase equipment on account. One transaction: –1) Purchase equipment and pay off account payable. Forex gains and losses increase or decrease the balance in the equipment account.

Comparative National Practices U.S. - Record two transactions and recognize gains and losses IAS 21- record two transactions and recognize gains and losses unless a country meets the requirements of severe devaluation and qualifies for an alternative treatment which allows the gains and losses to be included in the balance of the related asset.

Comparative National Differences Canada - basically same as U.S. but allows deferral and amortization of the gain/loss from long-term items Japan - allows deferral of gains/losses until transaction is settled France - record losses, defer gains Germany - record losses, defer gains U.K. - similar to Canada

Accounting for Debt Debt –Initially recorded at cost –Loan must be adjusted for foreign exchange rates at each balance sheet date Interest expense –Interest recorded using the average exchange rate which may be different from the ending balance sheet rate which determines cash paid

Derivatives Forward Contracts – contract between a foreign currency trader and a client for the future sale or purchase of foreign currency –Domestic currency to pay or receive in future is set –Contract must be exercised

Options Put options – right to sell Call options – right to buy American style – can be exercised any time up to the expiration date European style – can only be exercised on the last day of the option Exchanges trade options for a premium and a brokerage fee Options markets – Chicago Mercantile Exchange, Philadelphia Stock Exchange

Options If option is exercised, an additional premium must be paid If strike price = spot rate, do not exercise due to additional premium If strike price > spot rate, exercise if put option is “in the money” If strike price < spot rate, exercise if call

14 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. Accounting for Options

Foreign Exchange Markets Global foreign exchange = $1.5 trillion per business day Foreign exchange is mainly traded among interbanks or with financial intermediaries Currency trading among banks listed in Wall Street Journal daily Also on internet U.S. Dollar is strongest foreign exchange Most currency transactions involve the U.S. dollar, the E.U. euro, the British pound, the Japanese yen, and the Swiss franc.

International Monetary System Created in 1944 Primary purpose is to promote exchange stability Prior to 1973, fixed rate system based on gold standard (no longer exists) Exchange rate arrangements –Pegged to a single currency or a group of currencies (generally within 1%) –Flexible currencies which free float based on market conditions (most popular right now) SDRs - special drawing rights (IMF monetary measurements based on U.S., British and Japanese currencies.)

Currency Convertibility Not all currency is convertible You must have a willing buyer Depends on the strength of your currency Nonconvertible currencies tend to have trading restrictions and government controls Often a “black market” for nonconvertible currencies

Determination of Exchange Rates Purchasing power parity – after exchange rate conversion, prices for goods and services are generally the same (Big Mac index) Interest rates – generally practice has held that higher interest rates increase your exchange rate Inflation rates – high inflation lowers your exchange rate Trade balance of current and capital accounts affects exchange rates Ultimately supply and demand rule exchange rate

Hedging Hedging allows offsetting of gains and losses on derivatives and business transactions. Designed to protect any underlying account from foreign exchange risk Adds stability to business transactions made in foreign currency Forward contracts and options generally used Can also use futures (riskier)

Hedging Standards IAS 39 and U.S. - SFAS 133 and 138 Derivative: –Has one or more underlyings and one or more notional amounts or payment provisions, or both. –Requires no initial net investment –Its terms require or permit net settlement Basically, derivatives should be recorded as assets or liabilities in the balance sheet measured at fair values. Changes in fair values from one period to the next are recorded in income or accumulated other comprehensive income depending on the type of hedge.

Hedge Accounting Three criteria must be satisfied to use hedge accounting: 1.The derivative is used to hedge either a fair value exposure or cash flow exposure to foreign exchange risk. 2.The derivative is highly effective in offsetting changes in the fair value or cash flows related to the hedged item. 3.The derivative is properly documented as a hedge.

Hedging Fair-value hedge –A hedge of the exposure to changes in the fair value of a recognized asset or liability or an unrecognized firm commitment –Gains and losses go to current income Cash flow hedge –A hedge of the exposure to variability in the cash flows of a recognized asset or liability, firm commitments, or a forecasted foreign currency transaction –Gains and losses initially go to comprehensive income, then move to current income when forecasted transaction affects earnings.

Homework Problems 13, 14, 15, 16, 18, 20 Cases 6-2, 6-3 ALL DUE WITH EXAM, DECEMBER 16