Foreign Currency Transactions and Hedging Foreign Exchange Risk

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

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3. 3 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). A direct quote is the reciprocal of an indirect quote and vice-versa. For example, if the direct quote for a Euro was 1.3420, the indirect quote was 0.7452 (its inverse). Foreign Exchange Markets

4. 4 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.

5. 5 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). Exchange Rates and Foreign Exchange Risk

6. 6 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. Exchange Rates and Foreign Exchange Risk

7. 7 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.

8. 8 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. Accounting for Foreign Currency Transactions

9. 9 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. Accounting for Foreign Currency Transactions

10. 10 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. Accounting for Foreign Currency Transactions

11. 11 Example 1: Export sale � Joe Inc., makes sale and ships goods on December 1, 2005. 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. Payment is made on March 2, 2006 when the exchange rate is $.09 per peso. Accounting for Foreign Currency Transactions

12. 12 Export sale � example 1 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 Accounting for Foreign Currency Transactions

13. 13 Export sale � example 1 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 Accounting for Foreign Currency Transactions

14. 14 Hedging Foreign Exchange Risk Hedging -- protecting against losses from exchange rate fluctuations. Why Hedge? Allows firm to focus on what it does best, i.e., the business operation. Reduces earnings and cash flow volatility. Removes a noncontrollable element of risk that is not well understood or predictable.

15. How can firms hedge the FC risk they carry? Buy or sell the foreign currency now. Counterbalance the position by holding the opposite position within the balance sheet structure (e.g., receivables, notes, etc.) Set up a foreign operation that incurs expenses (sales) in the foreign currency. Use Derivatives: 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.

16. Options and Forwards Compared Forwards: Must buy or sell according to contract terms. Usually less expensive transaction costs. Options: Holder can walk away and simply not exercise the option. Thus, the holder can only gain but not lose. Usually a much more expensive hedging vehicle.

17. 17 Forward Contracts- Spot 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. Foreign Exchange Markets

18. Factors that drive the existence and level of discounts or premiums Inflation differences across nations Transaction costs Opportunity costs Expectations

19. 19 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.

20. 20 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 total foreign exchange loss, Joe would have paid, in effect, a $5,000 cost, in the form of a discount to spot, on the forward contract.

21. 21 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. Foreign Exchange Markets

22. 22 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. Foreign Exchange Markets

23. 23 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. The strike price is $ .11

24. 24 Hedging Foreign Exchange Risk Hedging risk on an export sale � example 2 Joe would now have the option to 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 only had the cost of $4,000 to purchase the option.

25. Under what circumstances does a foreign exchange risk exist?

26. Under what circumstances does FX risk exist? When a transaction occurs and exchange of goods and services is made. (An exposed asset/liability position) When goods and services are ordered and the firm is committed to sell or buy them (A firm commitment) . When it is known that goods and services will likely be sold or purchased in the future (a forecasted FC transaction).

27. 27 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.

28. Types of Hedges (as designated in GAAP) 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.

29. Why does the cash flow/fair value designation matter? Each designation triggers a different accounting method. The cash flow method focuses on matching and smooths income more. The fair value method focuses on the balance sheet.

30. 30 Hedge Accounting What decides whether a hedging instrument is considered to be a cash flow (flow) or fair value (stock) hedge? Management does. In other words, the choice is entirely arbitrary except for forecasted transactions (must be designated as a cash flow hedge).

31. The objectives of hedge accounting: Marking assets and liabilities to market. Amortizing, in some fashion, the costs of the hedge instrument. Matching gains/losses of the exposure with the hedge, thus causing them to offset each other.

32. In general For instruments designated as fair value hedges, gains and losses go directly to income. For instruments designated as cash flow hedges, gains and losses are matched to the underlying exposure, with the rest going to �other comprehensive income�.

33. In general Designation as a fair value hedge is essentially meaningless for exposed positions (and such designation creates lots of paperwork). For exposed positions, cash flow hedge treatment is thus preferred because losses are exactly matched to gains in the underlying exposure. As a result, earnings is better smoothed.

34. Hedge Accounting is complex because There are many combinations and they all have different end results (see pp 247-248).

35. 35 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).

36. 36 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.

37. In this case: There is a FX discount (Forward rate < spot rate) in the forward market. Because we are selling currency, this is a cost to us (If nothing happens, we�re out the amount of the discount). If we were buying currency (to hedge a purchase instead of a sale), the situation would reverse Premiums are also possible, and they can create costs or benefits as well.

38. Another complexity of derivatives accounting under both US GAAP and IFRS: Forward Contract Valuations on the balance sheet are adjusted for the time value of money. Example: Forward contract at 12/31 is valued at $ 9,000 (.105 - .096) x 1,000,000. The present value is $8911 ($9000/ (1.005)2).

39. 39 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

40. 40 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)

41. 41 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

42. 42 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

43. 43 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

44. 44 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

45. 45 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

46. 46 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.

47. 47 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 $ 13,000 ($0.013 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.

48. 48 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

49. 49 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 Foreign currency option 9,000 Accumulated Other Comprehensive Income 9,000 Option expense 1,333 Accumulated Other Comprehensive Income 1,333

50. 50 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 2,000 Accumulated Other Comprehensive Income 2,000

51. 51 Hedge Accounting Example 3, FC asset/option/cash flow hedge 3/02/06 Option expense 3,667 Accumulated Other Comprehensive Income 3,667 Cash 95,000 Accounts receivable 95,000 Cash 15,000 Foreign currency option 15,000

52. What, then, is the net effect of hedge accounting? Why would a company choose to use it? What are the pros and cons to this kind of financial reporting?

53. Firm Committments With orders that are firm commitments, companies also have foreign exchange risk. In this case, however, no underlying asset or liability exposure has yet been recorded. How then to treat the economic results of hedges using derivatives?

54. 54 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).

55. 55 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.

56. 56 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

57. 57 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

58. 58 Hedge Accounting Example 4, FC firm commitment/forward/fair value hedge 3/02/06 Cash 10,000 Forward contract 10,000 Firm commitment 10,000 Adjustment to net income 10,000

59. Thus, in hedge accounting for firm commitments, we have a strange result: FX related changes in value for the underlying exposure are accounted for before the related asset or liability is even recorded!

60. 60 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.

61. 61 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 $13,000 ($0.013 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.

62. 62 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

63. 63 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

64. 64 Hedge Accounting Example 5, FC firm commitment/option/fair value hedge 3/02/06 Cash 15,000 Foreign currency option 15,000 Firm commitment 15,000 Adjustment to net income 15,000

65. Forecasted Transactions With forecasted transactions, there may be FX risk. It depends on how reliable the forecast itself is. If there is FX risk, how can we recognize the economic implications of a hedge, when what is being hedged (a future transaction) is still unrecognized?

66. 66 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.

67. 67 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 value of the option on December 31, 2005 is $13,000 ($0.013 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.

68. 68 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 Foreign Currency Option 10,333 Accumulated Other Comprehensive Income 10,333 Option expense 1,333 Foreign currency option 1,333

69. 69 Hedge Accounting Example 6, Forecasted FC transaction/ option/cash flow hedge 3/02/06 Option expense 2,667 FC Option 2,667 Foreign currency option 4,667 Accumulated Other Comprehensive Income 4,667 Foreign currency 95,000 Sales 95,000

70. 70 Hedge Accounting Example 6, Forecasted FC transaction/ option/cash flow hedge 3/02/06 Cash 15,000 Foreign currency option 15,000 Accumulated Other Comprehensive Income 15,000 Adjustment to net income 15,000

71. To summarize: FX hadging transactions raise interesting accounting questions. At the heart of the matter is a major accounting problem: how to account for the future, in this case, in the form of executory contracts and/or contingencies.