1. © The McGraw-Hill Companies, Inc., 2004 Slide 9-1 McGraw-Hill/Irwin Chapter Nine Foreign Currency Transactions and Hedging Foreign Exchange Risk

2. © The McGraw-Hill Companies, Inc., 2004 Slide 9-2 McGraw-Hill/Irwin Foreign 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.

3. © The McGraw-Hill Companies, Inc., 2004 Slide 9-3 McGraw-Hill/Irwin Exchange 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.

4. © The McGraw-Hill Companies, Inc., 2004 Slide 9-4 McGraw-Hill/Irwin Foreign Exchange Rates Exchange rates are published daily in the Wall Street Journal.  These are “end-of- day” rates.  As of 4:00pm Eastern time Remember – Rates change constantly during the day Exchange rates are published daily in the Wall Street Journal.  These are “end-of- day” rates.  As of 4:00pm Eastern time Remember – Rates change constantly during the day

5. © The McGraw-Hill Companies, Inc., 2004 Slide 9-5 McGraw-Hill/Irwin Foreign 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. As the relative strength of a country’s economy changes...... the exchange rate of the local currency relative to other currencies also fluctuates.

6. © The McGraw-Hill Companies, Inc., 2004 Slide 9-6 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 Forward Contracts A forward contract requires the purchase of currency units at a future date at the contracted exchange rate.

7. © The McGraw-Hill Companies, Inc., 2004 Slide 9-7 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! Foreign Exchange Options Contracts An options contract gives the holder the option of buying the currency units at a future date at the contracted “strike” price.

8. © The McGraw-Hill Companies, Inc., 2004 Slide 9-8 McGraw-Hill/Irwin Foreign Currency Transactions A U.S. company buys or sells goods or services to a party in another country. The transaction is often denominated in the currency of the foreign party. The major accounting issue: How do we account for the changes in the value of the foreign currency? The major accounting issue: How do we account for the changes in the value of the foreign currency?

9. © The McGraw-Hill Companies, Inc., 2004 Slide 9-9 McGraw-Hill/Irwin Foreign Currency Transactions FASB No. 52 Requires a two-transaction perspective. (1)Account for the original sale in US $ (2)Account for gains/losses from exchange rate fluctuations. FASB No. 52 Requires a two-transaction perspective. (1)Account for the original sale in US $ (2)Account for gains/losses from exchange rate fluctuations.

10. © The McGraw-Hill Companies, Inc., 2004 Slide 9-10 McGraw-Hill/Irwin ? Foreign Currency Transactions... but the cash flow is at a later date...... fluctuating exchange rates can result in exchange rate gains or losses. When a transaction occurs on one date (for example a credit sale)...

11. © The McGraw-Hill Companies, Inc., 2004 Slide 9-11 McGraw-Hill/Irwin ? Foreign Currency Transactions When the rate is expressed as the US $ equivalent of 1 unit of foreign currency, the rate is called a “DIRECT QUOTE” When the rate is expressed as the US $ equivalent of 1 unit of foreign currency, the rate is called a “DIRECT QUOTE”

12. © The McGraw-Hill Companies, Inc., 2004 Slide 9-12 McGraw-Hill/Irwin Foreign Currency Transactions When the rate is expressed as the US $ equivalent of 1 unit of foreign currency, the rate is called a “DIRECT QUOTE” When the rate is expressed as the US $ equivalent of 1 unit of foreign currency, the rate is called a “DIRECT QUOTE” When the rate is expressed as the number of foreign currency units that $1 will buy, the rate is called an “INDIRECT QUOTE” When the rate is expressed as the number of foreign currency units that $1 will buy, the rate is called an “INDIRECT QUOTE”

13. © The McGraw-Hill Companies, Inc., 2004 Slide 9-13 McGraw-Hill/Irwin Foreign Exchange Transaction Example On 12/1/04, 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 =.6425 £. Prepare BobCo’s journal entry. On 12/1/04, 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 =.6425 £. Prepare BobCo’s journal entry.

14. © The McGraw-Hill Companies, Inc., 2004 Slide 9-14 McGraw-Hill/Irwin Foreign Exchange Transaction Example On 12/31/04, the exchange rate is $1 =.6400 £. At the balance sheet date we have to “remeasure”, or adjust, the original A/R to the current exchange rate. On 12/31/04, the exchange rate is $1 =.6400 £. At the balance sheet date we have to “remeasure”, or adjust, the original A/R to the current exchange rate.

15. © The McGraw-Hill Companies, Inc., 2004 Slide 9-15 McGraw-Hill/Irwin Foreign Exchange Transaction Example On 3/1/05, Coventry Corp. pays BobCo the 10,000 £ for the 12/1/04 sale. The exchange rate on 3/1/05, was $1 =.6500 £. On 3/1/05, we have to do TWO things. First, we have to “remeasure” the A/R.

16. © The McGraw-Hill Companies, Inc., 2004 Slide 9-16 McGraw-Hill/Irwin Foreign Exchange Transaction Example On 3/1/05, Coventry Corp. pays BobCo the 10,000 £ for the 12/1/04 sale. The exchange rate on 3/1/05, was $1 =.6500 £. On 3/1/05, we have to do TWO things. Second, we have record the receipt of the £.

17. © The McGraw-Hill Companies, Inc., 2004 Slide 9-17 McGraw-Hill/Irwin Hedging Foreign Exchange Risk To control for the risk of exchange rate fluctuation, a forward contract for currency can be purchased. Hedging effectively reduces the uncertainty associated with fluctuating exchange rates.

18. © The McGraw-Hill Companies, Inc., 2004 Slide 9-18 McGraw-Hill/Irwin Hedging Foreign Exchange Risk To hedge a foreign currency transaction, companies use foreign currency derivatives Two most common tools:  Foreign currency forward contracts  Foreign currency options