Chapter 7:�Foreign Currency Transactions �and Hedging Foreign �Exchange Risk

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Learning Objectives

• Provide an overview of the foreign exchange market
• Explain how fluctuations in exchange rates give rise to foreign exchange risk
• Demonstrate the accounting for foreign currency transactions
• Describe how foreign currency forward contracts and foreign currency options can be used to hedge foreign exchange risk
• Describe the concepts of cash flow hedges, fair value hedges, and hedge accounting

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Learning Objectives

• 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.

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Foreign Exchange Markets

• Foreign exchange rate
• Purchase price of a foreign currency
• 1945 –1973
• Exchange rates fixed in U.S. dollar
• U.S. dollar was fixed in gold
• U.S. dollar was fixed to gold at $35 per ounce
• 1960s Balance-of-payments deficits in the U.S.
• March 1973 most currencies float in value

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Foreign Exchange Markets

• Exchange Rate Mechanisms
• Independent float
• Currency value allowed to move freely
• Little government intervention
• Pegged to another currency
• Currency value fixed in terms of a foreign currency
• E.g. U.S. dollar
• Central bank maintains the exchange rate
• European Monetary System (Euro)
• Twelve countries use a single currency,
• Floats against other currencies
• E.g. U.S. dollar

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Foreign Exchange Markets

• Foreign Exchange Rates
• Interbank rates
• Wholesale prices
• Banks charge one another
• Exchange of currencies
• Published on the internet and in newspapers
• Reflected
• Direct quotes (US $ equivalent)
• Indirect quotes (currency per US $)
• Direct quote reciprocal of indirect quote
• Indirect quote reciprocal of direct quote

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Foreign Exchange Markets

• Spot rates
• 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
• Forward rate is greater than the spot rate
• Discount
• Forward rate is less than the spot rate

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Foreign Exchange Markets

• Option contracts
• Foreign currency option
• Gives right, no obligation
• Trade foreign currency
• Trade in future
• Put option
• Option to sell the foreign currency
• Call option
• Option to buy the foreign currency
• Strike price
• Exchange rate at which currency will be exchanged when option is exercised

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Foreign Exchange Markets

• Option contracts
• Option premium
• Cost of purchasing the option
• Function of the option’s intrinsic value and time value
• Intrinsic value
• Immediate exercise of the option
• Gain
• Time value
• Derived value
• Currency value increase
• During the remainder of the option period

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Foreign Currency Transactions

• Transaction exposure
• Exposure to foreign exchange risk
• Export sale
• Sale to foreign customer
• Later payment
• In customer’s currency
• Import purchase
• Purchases from foreign supplier
• Payment in the supplier’s currency
• Foreign exchange risk
• Change in the exchange rate results in
• Exporter will receive less
• Importer will pay more than anticipated

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Foreign Currency Transactions

• 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)

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Foreign Currency Transactions

• 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) and Joe receives $10,000 less due to exchange rate fluctuation.

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Accounting for Foreign Currency Transactions

• One transaction perspective
• Treats sale and collection as one transaction
• Transaction complete when
• Foreign currency received and converted
• Sale is measured at converted amount
• Not allowed under IAS or U.S. GAAP

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Accounting for Foreign Currency Transactions

• Two transaction perspective
• Two transactions
• Sale
• Collection
• Sale based on current exchange rate
• Exchange rate changes
• Collection for different amount
• Difference considered
• Foreign exchange gain
• Foreign exchange loss
• Concepts are identical for purchase transaction
• (IAS) 21 and FASB ASC 830 require two-transaction perspective

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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

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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

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Accounting for Foreign Currency Transactions

• Export sale – example 1
• February 1, 2012, 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, 2012.
• Assume spot rate as of February 1, 2011 is $0.10 per peso.

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Accounting for Foreign Currency Transactions

• Export sale – example 1
• Joe, Inc. records the sale (in U.S. $) on February 1, 2011 as follows:

Accounts Receivable 100,000

Sales 100,000

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Accounting for Foreign Currency Transactions

• Export sale – example 1
• On March 2, 2011, 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

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�Accounting for Foreign Currency Transactions

• Export sale – example 2
• Assume the following facts are added or changed:
• Joe Inc., makes sale and ships goods on December 1, 2010 rather than February 1, 2011.
• Spot rate as of December 1, 2010 is $0.11 per peso.
• Spot rate as of December 31, 2010 is $0.105 per peso.
• Joe Inc. has a December 31 year end.

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Accounting for Foreign Currency Transactions

• Export sale – example 2
• Joe, Inc. records the sale (in U.S. $) on December 1, 2010 and the foreign exchange loss on December 31, 2010 as follows:
• Accounts Receivable 110,000
• Sales 110,000
• Foreign Exchange Loss 5,000
• Accounts Receivable 5,000

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Accounting for Foreign Currency Transactions

• Export sale – example 2
• Joe, Inc. records the receivable collection and an additional foreign exchange loss on March 2, 2011:
• Cash 90,000
• Foreign Exchange Loss 15,000
• Accounts Receivable 105,000

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Hedging Foreign Exchange Risk

• Hedging
• Protects from exchange rate fluctuations
• Foreign currency forward contracts
• Foreign currency options
• Foreign currency forward contract
• Buy or sell foreign currency
• Future date
• Foreign currency option
• Right to buy or sell foreign currency
• For a period of time

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Hedging Foreign Exchange Risk

• Derivative
• Hedge accounting appropriate if derivative
• Used to hedge an exposure
• Highly effective In offsetting changes in
• Fair value
• Cash flows related to the hedged item
• Properly documented as a hedge

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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, 2010.

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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, 2011.
• 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.

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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, 2010.
• The option premium is $4,000.

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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, 2011.
• 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.

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Cash Flow Hedges, Fair Value Hedges, and Hedge Accounting

• Hedge accounting
• Offsetting gain or loss
• Recognized in net income
• In same period as
• The gain or loss from the hedged item
• Cash flow hedge
• An accounting designation for hedges
• Offset variability in cash flows
• Fair value hedge
• Accounting designation for hedges
• Offset variability in fair value of hedged assets and liabilities

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Hedge Accounting

• 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

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Hedge Accounting

• Assumptions for examples 1 and 2
• December 1, 2010, 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, 2011.
• Spot rates per peso are: December 1, 2010, $0.11, December 31, 2010, $0.10, and March 2, 2011, $0.095.
• The annual interest rate is 6% (0.5% per month).

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Hedge Accounting

• Joe enters a foreign currency forward contract on December 1, 2010.

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• The contract calls for Joe to sell 1,000,000 pesos at a forward rate of $0.105, on March 2, 2011.

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• The forward rate on December 31, 2010 for March 2, 2011 delivery is $0.096.

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Hedge Accounting

• Example 1, FC asset/forward/cash flow hedge

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• 12/01/10

Accounts receivable 110,000

Sales 110,000

• 12/31/10

Foreign exchange loss 10,000

Accounts receivable 10,000

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Accumulated other comprehensive income 10,000

Gain on forward contract 10,000

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• 12/31/10

Forward contract 8,911

Accumulated Other Comprehensive Income 8,911

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Hedge Accounting

• Example 1, FC asset/forward/cash flow hedge

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Discount expense 1,667

Accumulated Other Comprehensive Income 1,667

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(discount expense is amortized using the straight-line method)

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Hedge Accounting

• Example 1, FC asset/forward/cash flow hedge

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3/02/11

Foreign exchange loss 5,000

Accounts receivable 5,000

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Accumulated Other Comprehensive Income 5,000

Gain on forward contract 5,000

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Forward contract 1,089

Accumulated Other Comprehensive Income 1,089

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Hedge Accounting

• Example 1, FC asset/forward/cash flow hedge

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3/02/11

Discount expense 3,333

Accumulated Other Comprehensive Income 3,333

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Foreign currency 95,000

Accounts receivable 95,000

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Cash 105,000

Foreign currency 95,000

Forward contract 10,000

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Hedge Accounting

• Example 2, FC asset/forward/fair value hedge

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12/01/10

Accounts receivable 110,000

Sales 110,000

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12/31/10

Foreign exchange loss 10,000

Accounts receivable 10,000

Forward contract 8,911

Gain on forward contract 8,911

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Hedge Accounting

• Example 2, FC asset/forward/fair value hedge

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3/02/11

Foreign exchange loss 5,000

Accounts receivable 5,000

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Forward contract 1,089

Gain on forward contract 1,089

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Hedge Accounting

• Example 2, FC asset/forward/fair value hedge

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3/02/11

Foreign currency 95,000

Accounts receivable 95,000

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Cash 105,000

Foreign currency 95,000

Forward contract 10,000

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End of Chapter 7

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