C o p y r g h © b y T h Chapter Nine Foreign Currency Transactions and Hedging Foreign Exchange Risk Copyright © 2015 McGraw-Hill Education All rights reserved No reproduction or distribution without the prior written consent of McGraw-Hill Education C o p y r Learning Objective 9-1 g h © b y T h Understand concepts related to foreign currency, exchange rates, and foreign exchange risk 9-2 Exchange Rate Mechanisms Between 1945 and 1973, countries fixed the par value of their currency in terms of the U.S dollar The U.S dollar was based on the Gold Standard until 1971 Since 1973, exchange rates have been allowed to float in value Several currency arrangements exist 9-3 Different Currency Mechanisms Independent Float - the currency is allowed to fluctuate according to market forces Pegged to another currency - the currency’s value is fixed in terms of a particular foreign currency, and the central bank will intervene to maintain the fixed value European Monetary System - a common currency (the euro) is used in multiple countries Its value floats against other world currencies 9-4 Foreign Exchange Rates An Exchange Rate is the cost of one currency in terms of another Rates published daily in the Wall Street Journal are as of 4:00pm Eastern time on the day prior to publication Rates are also available on line at: www.oanda.com and http://www.x-rates.com The published rates are wholesale rates that banks use with each other – retail rates to consumers are higher The difference between the rates at which a bank is willing to buy and sell currency is known as the “spread.” Rates change constantly! 9-5 Foreign Exchange Rates Spot Rate The exchange rate that is available today Forward Rate 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 A forward contract requires the purchase (or sale) of currency units at a future date at the contracted exchange rate 9-6 C o p y r g h © b y T h Foreign Exchange – Option Contracts An options contract gives the holder the option of buying (or selling) currency units at a future date at the contracted “strike” price A “put” option allows for the sale of foreign currency by the option holder A “call” option allows for the purchase of foreign currency by the option holder An option gives the holder “the right but not the obligation” to trade the foreign currency in the future 9-7 Option values Value is derived from : A function of the difference between current spot rate and strike price The difference between foreign and domestic interest rates The length of time to option expiration The potential volatility of changes in the spot rate An option premium is a function of Intrinsic Value and Time Value 9-8 C o p y r g h © b y T h Learning Objective 9-2 Account for foreign currency transactions using the two transaction perspective, accrual approach 9-9 Foreign Currency Transactions A U.S company buys or sells goods or services to a party in another country This is often called foreign trade The transaction is often denominated in the currency of the foreign party How we account for the changes in the value of the foreign currency? 9-10 Foreign Currency Option as a Hedge An option is a contract that allows you to exercise a predetermined exchange rate if it is to your advantage As with forward contracts, options can be designated as cash flow hedges or fair value hedges Option prices are determined using the Black-Scholes Option Pricing Model covered in most finance texts 9-30 C o p y r g h © b y T h Learning Objective 9-5 Account for forward contracts and options used as hedges of foreign currency firm commitments 9-31 C o p y r g h © b y T h Foreign Currency Firm Commitment Hedge A firm commitment is an executory contract not normally recognized in financial statements; the company has not delivered goods nor has the customer paid for them When a firm commitment is hedged using a derivative financial instrument, hedge accounting requires explicit recognition on the balance sheet at fair value of both the derivative financial instrument and the firm commitment 9-32 C o p y r g h © b y T h Foreign Currency Firm Commitment Hedge Changes in the spot exchange rate are used to determine the fair value of the firm commitment when a foreign currency option is the hedging instrument U.S GAAP allows hedges of firm commitments to be designated either as cash flow or fair value hedges 9-33 C o p y r Foreign Currency Firm Commitment Hedge g h Options are carried at fair value on the balance sheet of both the derivative financial instrument (forward contract or option) and the firm commitment © b y T h The change in value of the firm commitment gain/loss offsets the gain or loss on the hedging instrument Gain/loss is recognized currently in net income, as is the gain/loss on the firm commitment attributable to the hedged risk 9-34 C o p y r g h © b y T h Learning Objective 9-6 Account for forward contracts and options used as hedges of forecasted foreign currency transactions 9-35 Hedge of a Forecasted Foreign Currency Denominated Transaction Cash flow hedge accounting may be used for foreign currency derivatives associated with a forecasted foreign currency transaction The forecasted transaction must be probable, highly effective, and the hedging relationship must be properly documented There is no recognition of the forecasted transaction or gains and losses on the forecasted transaction 9-36 Hedge of a Forecasted Foreign Currency Denominated Transaction The company reports the hedging instrument (forward contract or option) at fair value, but changes in the fair value of are not reported in net income Gains and losses on the hedging instrument are recorded in Other Comprehensive Income until the date of the forecasted transaction then transferred to net income on the projected transaction date 9-37 C o p y r Learning Objective 9-7 g h © b y T h Prepare journal entries to account for foreign currency borrowings 9-38 Foreign Currency Borrowings Companies often must account for foreign currency borrowings, another type of foreign currency transaction Companies borrow foreign currency from foreign lenders to finance foreign operations or to take advantage of more favorable interest rates The facts that the principal and interest are denominated in foreign currency and create an exposure to foreign exchange risk complicate accounting for a foreign currency borrowing 9-39 Journal Entries 9-40 Foreign Currency Borrowings Companies also lend foreign currency to related parties, creating the opposite situation from a foreign currency borrowing The company must keep track of a note receivable and interest receivable, both of which are denominated in foreign currency Fluctuations in the U.S dollar value of the principal and interest generally give rise to foreign exchange gains and losses that would be included in income 9-41 IFRS—Foreign Currency Transactions and Hedges There are no substantive differences between U.S GAAP and IFRS in accounting for foreign currency transactions Similar to U.S GAAP, IAS 21, “The Effects of Changes in Foreign Exchange Rates,” requires the use of a two-transaction perspective in accounting for foreign currency transactions with unrealized foreign exchange gains and losses accrued in net income in the period of exchange rate change 9-42 IFRS—Foreign Currency Transactions and Hedges IAS 39, “Financial Instruments: Recognition and Measurement,” governs accounting for hedging instruments including those used to hedge foreign exchange risk One difference between the two sets of standards relates to the type of financial instrument designated as a foreign currency cash flow hedge U.S GAAP allows only derivative financial instruments to be used as a cash flow hedge IFRS allows nonderivative financial instruments 9-43 IFRS—Foreign Currency Transactions and Hedges In 2010, the IASB proposed a new hedge accounting model that would result in significant differences between IFRS and U.S GAAP In 2012, the IASB issued a draft of a forthcoming statement that would move hedge accounting from IAS 39 to IFRS 9, “Financial Instruments,” to implement the new model which would go into effect in 2015 IFRS is intended to more closely align accounting with a company’s risk management activities 9-44 ... derivatives for hedging purposes or for speculation 9-23 C o p y r g h © b y T h Accounting for Derivatives U.S GAAP allows hedge accounting for foreign currency derivatives only if three conditions are... currency payables from an import purchase creates a liability exposure to foreign exchange risk 9-15 Accounting for Unrealized Gains and Losses Under the two-transaction perspective, a foreign exchange... paid or received and a realized foreign exchange gain or loss is included in income when paid 9-16 Accounting for Unrealized Gains and Losses Accrual approach (required by U.S GAAP): Unrealized foreign