1. Derivatives and Foreign Currency: Concepts and Common Transactions
Chapter 12
Derivatives and Foreign Currency: Concepts and Common Transactions
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Derivatives and Foreign Currency – Concepts and Common Transactions: Objectives
Understand the definition of a derivative and the types of risks that derivatives can manage.
Understand the structure, benefits and costs of options, futures, forward contracts, and swaps.
Understand key concepts related to foreign currency exchange rates, such as indirect and direct quotes; floating, fixed, and multiple exchange rates; and spot, current, and historical exchange rates.
Explain the difference between receivable or payable measurement and denomination.
Record foreign currency-denominated sales/receivables and purchases/payables at the initial transaction date, year-end, and the receivable or payable settlement date.
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Derivatives and Foreign Currency:
Concepts and Common Transactions
1: DERIVATIVES
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4. Derivative (definition)
The name given to a broad range of financial securities.
The derivative's value to the investor is directly related to fluctuations in price, rate or some other variable that underlies it.
A derivative can be used to offset (“hedge”) the potential fluctuation in
Interest rates
Commodity prices
Foreign currency exchange rates
Stock prices
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5. Using Derivatives as Hedges
A hedge can
Shift risk of fluctuations in sales prices, costs, interest rates, or currency exchange rates
Help manage costs
Reduce risks to improve financial position
Produce tax benefits
Help avoid bankruptcy
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Derivatives and Foreign Currency:
Concepts and Common Transactions
2: Types of DERIVATIVES
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Derivatives
The four basic types of derivatives are:
Forward Contracts
Futures Contracts
Options
Swaps
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Forward Contracts
Forward Contracts are
Negotiated contracts between two parties
For the delivery or purchase of
A commodity or
A foreign currency
At an agreed upon price, quantity, and delivery date.
Settlement of the forward contract may be
Physical delivery of the good, or
Net settlement
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Futures Contracts
Futures contracts are a specific type of forward contract
Characteristics are standardized
Characteristics are set by futures exchanges (Rather than by the contracting parties) so performance risk is eliminated
Exchange guarantees performance
Settlement may also be made by entering another futures contract in the opposite direction.
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Options
Options are right (but not the obligation) to either
Call (buy), or
Put (sell)
With options, only one party is obligated to perform depending on the election of the other party to exercise their option.
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Swaps
Swaps are contracts to exchange an ongoing stream of cash flows, commonly swapping interest rates.
Swap variable- for fixed-rate debt, or
Swap fixed- for variable-rate debt
Swaps are commonly negotiated on an individual basis like forward contracts, but may be standardized and exchange-traded like futures.
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12. Example: Forward Contract
Sam decides to sell future production by entering into a forward contract with Irene for delivery of 10,000 items in one year at a price of $10 per item. Thus, Sam has determined their selling price regardless of the market, and Irene has locked in her purchase price. Sam risks loss of potential revenue if the market price for the items increases in the next year. Irene risks loss of potential savings if the market price for the items decreases in the next year.
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13. Forward Contract Impact
If Sam’s fixed costs are $50,000, and the variable cost is $3 per unit, Sam will lock in profit of $20,000 ($100,000 revenue less $50,000 fixed costs less $30,000 variable costs). If the market price for the item increases, Sam can sell at the higher market price and settle with Irene by paying her the difference, or simply sell the items to Irene at the contracted price. Either way, Sam has profit of $20,000.
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14. 3: Foreign currency exchange
Derivatives and Foreign Currency:
Concepts and Common Transactions
3: Foreign currency exchange
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15. Measurement and Denomination
Measured in a currency
Recorded in the financial records in that currency
Denominated in a currency
Requires settlement (payment or receipt) in that currency
For U.S. firms
U.S. dollar is the measurement currency
Payables and receivables may be denominated in U.S. dollars or other currencies
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16. Quoting Exchange Rates
Direct quotation (U.S. dollars per one foreign currency unit)
$1.60 (U.S. dollars) for £1 (British pound)
Indirect quotation (foreign currency units per one U.S. dollar)
£0.625 (British pounds) for $1 (U.S. dollar)
Direct and indirect quotes are reciprocals
£1 / $1.60 = £0.625
$1 / £0.625 = $1.60
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17. Establishing Exchange Rates
Exchange rates may be fixed by a governmental unit or may be allowed to fluctuate (float) with changes in the currency markets.
Official (fixed) exchange rates are set by a government and do not fluctuate with the changes in the world currency markets.
Free (floating) exchange rates reflect the fluctuating market prices for a currency based on supply and demand and other factors in the world currency markets.
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18. Various Exchange Rates
Spot rate
Exchange rate for immediate delivery
Current rate
Exchange rate at balance sheet date, or
Exchange rate at the time a transaction takes place
Historical rate
Exchange rate that existed when a specific transaction or event occurred
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19. 4: Sales and purchases denominated in foreign currency
Derivatives and Foreign Currency:
Concepts and Common Transactions
4: Sales and purchases denominated in foreign currency
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20. Currency Denomination
A company’s functional currency is the currency in which they transact the majority of their business. A foreign currency transaction is any transaction that is measured and settled (“denominated”) in a currency other than the company’s functional currency.
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Foreign Exchange Risk
Foreign Exchange Risk is the risk that the functional currency and the currency used in the transaction will change in value compared to each other, and the company will lose money as a result.
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22. 5: Recording foreign currency transactions
Derivatives and Foreign Currency:
Concepts and Common Transactions
5: Recording foreign currency transactions
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23. Foreign Currency Purchases
Purchases on account denominated in a foreign currency are subject to risk.
Changes in the foreign exchange rate may
Increase Accounts Payable, resulting in an exchange loss, or
Decrease Accounts Payable, resulting in an exchange gain
Foreign currency Accounts Payable is adjusted to fair value each period until paid.
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24. Foreign Currency Sales
Sales on account denominated in a foreign currency are subject to risk.
Changes in the foreign exchange rate may
Increase Accounts Receivable, resulting in an exchange gain, or
Decrease Accounts Receivable, resulting in an exchange loss
Foreign currency Accounts Receivable is adjusted to fair value each period until collected.
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25. Example: Purchase on Account
On 11/1, Sam purchases inventory for 500 euros on account. Sam pays for these goods on 1/30. Pertinent rates:
Date
Spot rate
Acct Pay
Gain (Loss)
11/1
$1.35
$675
12/31
$1.36
$680
$(5)
1/30
$1.38
$690
$(10)
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26. Purchase on Account - Entries
11/1
Inventory
675
Account Payable(euros)
12/31
Exchange loss 5
1/30
Cash (euros)
690
Cash ($)
  1/30
Account Payable (euros)
680
  10
Adjust payable to current rate.
Convert dollars to euros so proper funds are available for payment.
Make payment in euros, recognizing additional loss.
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27. Example: Sale on Account
On 11/1, Sam sells goods for 500 euros on account. The customer pays on 1/30 and cash is converted on that date. Pertinent rates:
Date
Spot rate
Acct Rec
Gain (Loss)
11/1
$1.35
$675
12/31
$1.36
$680 $5
1/30
$1.38
$690
$10
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28. Sale on Account - Entries
11/1
Accounts receivable (euros)
675
Sales
12/31 5
Exchange gain
1/30
Cash (euros)
690
Acct receivable (euros)
680 10
Cash ($)
Adjust receivable to current rate.
Collect from customer, recognizing additional gain
Convert funds.
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