Foreign Currency Transaction and Hedging Foreign Exchange Risk

Question 1

Spot rates

Answer 1

price at which foreign currency can be purchased or sold today.

Question 2

Forward rate

Answer 2

price today at which foreign currency can be purchased or sold sometime in the futre

Question 3

forward rate premium

Answer 3

forward rate exceeds spot rate on a given date

Question 4

Forward rate discount

Answer 4

forward rate is less than spot rate

Question 5

Option types

Answer 5

put (right to sell), call (right to purchase) at the strike price

Question 6

strike price

Answer 6

exchange rate at which the option will be executed if the option holder decides to exercise the option

Question 7

Where are foreign currency options purchased?

Answer 7

Philidelphia Stock Exchange, Chicago Mercantil Exchange, or over the counter directly from a bank

Question 8

option premium

Answer 8

price of the option based on intrinsic value (gain that could be realized by exercising the option immediately) and time value

Question 9

Intrinsic value of an option

Answer 9

gain that could be realized by exercising the option immediately.
Ex: if a spot rate for a foreign currency is 1, a call option with a strike price of .97 has an intrinsic value of .03, and it is “in the money”

Question 10

In the money

Answer 10

option with a positive intrinsic value

Question 11

Time value of an option

Answer 11

The spot rate can change over time and cause the option to become in the money. Even though a 90-dat call option with a strike price of 1 has a zero intrinsic value when the spot rate is $1, it will still have a positive time vale because there is a chance that the spot rate could increase over the next 90 days and bring the option into the money

Question 12

Value of a foreign currency option

Answer 12

Black scholes option pricing formula
The value of an option is a function of the difference between the current spot rate and strike price, the difference between domestic and foreign interest rates, the length of time to expiration, and the potential volatility of changes in the spot rate

Question 13

Export sale

Answer 13

Exporter allows the buyer to pay in foreign currency and allows buyer to pay sometime after sale has been made. Risk si that the foreign currency might depreciate

Question 14

Import Purchase

Answer 14

Transaction exposure exists when importer is required to pay in foreign currency is allowed to pay sometime after purchase has been made. The importer is exposed to risk that the foreign currency might appreciate between date of purchase and date of payment.

Question 15

Two transaction perspective

Answer 15

Required by GAAP. It treats the export sale and subsequent collection of cash as two separate transactions because management has made 2 decisions…. to make export sale and to extend credit in foreign currency to customer. The company should report the income effect from each of these decisions separately. The US dollar value of the sale is recorded at date the sale occurs.

Question 16

Asset Exposure vs Liability Exposure

Answer 16

Asset exposure is from export sales. When foreign currency appreciates, there is a gain. When it depreciates, there is a loss

For Liability exposure, its usually an import purchase. If foreign currency appreciates, there is a loss and if it depreciates there is again.

Question 17

Accrual approach

Answer 17

Required by US GAAP to account for foreign exchange gains and losses. A firm reports unrealized foreign ex gains and losses in net income in the period in which the exchange rate changes.

Criticism: leads to violation of conservatism when an unrealized foreign exchange gain arises at the balance sheet date. The only other exception in GAAP is with trading marketable securities reported at fair value.

Question 18

Foreign Currency derivatives

Answer 18

Purpose is to hedge against risk and avoid uncertainty.

Most common are. Foreign currency forward contracts and Foreign currency options

Question 19

When enter into a hedging arrangement

Answer 19

as soon as they receive a noncancelable sales order or place a noncancelable purchase order (foreign currency firm commitment).

Question 20

Fundamental requirements of Derivatives Accounting

Answer 20

Companies carry all derivatives on balance sheet at fair value.

Question 21

Fair value of a foreign currency forward contract

Answer 21

Determined by reference to changes in the forward rate over the life of the contract, discounted to present value. It is necessary to have the forward rate when forward contract was signed, current forward rate for a contract that matures on the same date as the forward contract entered into, and a discount rate (typically the company’s incremental borrowing rate).

Question 22

Fair value of a foreign currency option

Answer 22

For over the counter, fair value is the price quote from an option dealer (like a bank), if unknown, the black scholes option pricing model, for exchange-traded, its the current market price on the exchange.

Question 23

Changes in Fair value of derivatives are included in

Answer 23

comprehensive income

Question 24

comprehensive income

Answer 24

all changes in equity from nonowner sources. It consists of net income and other comprehensive income

Question 25

Hedge Accounting

Answer 25

Recognition of gains and losses on the hedging instruments in same period as the recognition of gains and losses on underlying hedged asset or liability (or firm commitment). For eligibility, the derivative must be used to hedge a fair-value exposure or cash flow exposure to foreign exchange risk, it must be highly effective in offsetting changes in the fair value or cash flows related to hedged item, and must be properly documented as a hedge

Question 26

Nature of Hedged Risk

Answer 26

Fair Value or Cash Flow Exposure

Question 27

Fair value exposure

Answer 27

exists when changes in exchanges rates affect fair value of an asset or liability reported on the balance sheet.

Question 28

Cash flow exposure

Answer 28

If changes in exchange rates can affect amount of cash flow to be realized from a transaction with changes in cash flow reflected income. Cash flow exposure exists for 1) recognized foreign currency assets and liabilities, 2) foreign currency firm commitments, and 3)forecasted foreign currency transactions.

Question 29

Hedge documentation

Answer 29

Documentation at the inception of the hedge that identifies hedged item, hedging instrument, nature of the risk being hedged, how the hedging instruments' effectiveness will be assessed, and risk management objective and strategy for undertaking the hedge.

Question 30

Would a company prefer the fair value hedge or cash flow hedge? Why?

Answer 30

Most would prefer the cash flow hedge because they only recognize gains and losses of the derivative instruments to the extent it offsets the item being hedged, and the rest gets stored in AOCI for deferral. The company knows what the total expense is going to be as soon as the contract is signed. Fair Value, has greater potential for volatility in periodic net income

Question 31

Forward Contract--Cash Flow hedge

Answer 31

1. Record sales revenue using the spot rate 2. At the end of the period, adjust asset to fair value based on changes in spot rate and recognize a gain 3. Recognize the accompanying reduction in fair value of the forward contract with corresponding change to AOCI 4. Take the loss from Forward contract equal to the gain from the transaction with corresponding affect to AOCI 5. Allocate forward contract discount to net income over life of contract using effective interest method.

Question 32

Forward Contract-- Fair Value Hedge

Answer 32

1. Record sales revenue using the spot rate 2. At end of period, adjust asset to fair value based on changes in spot rate and recognize a gain. 3. Recognize corresponding loss on forward contract and reduce the balance sheet value of the Forward Contract

Question 33

Option--Cash Flow Hedge

Answer 33

1. Record sale at spot rate 2. Record foreign currency option at fair value as an option that you paid with Cash 3. At the end of the period, adjust the value of asset to new spot rate and record gain 4. Adjust the fair value of the option with corresponding adjustment to accumulated other comprehensive income 5. Recognize a loss on foreign currency option equal to the gain on the underlying hedged asset. 6. Recognize change in time value of the option as an expense with corresponding adjustment to AOCI

Question 34

Option--Fair Value hedge

Answer 34

1. Record sale at spot rate 2. Record foreign currency option at fair value as an option that you paid with Cash 3. At the end of the period, adjust the value asset to new spot rate and record gain from appreciation of currency. 4. Recognize a corresponding loss on foreign currency option with a corresponding decrease of option value on balance sheet

Question 35

Forward Contract used as a fair value hedge of a firm commitment--Fair Value

Answer 35

1. No entry to record the inception because these are executor contracts. A memo designates forward contract as a hedge of the risk changes in the fair value of the firm commitment resulting from changes in exchange rates 2. At the end of the period, record the Forward contract as an asset/liability and a corresponding gain/loss on forward contract 3. The firm commitment is recorded as an asset/liability at its fair value with a corresponding gain/loss

Question 36

What is the fair value of a firm commitment?

Answer 36

A firm commitment is an executor contract, and is usually not in financial statements. But 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 (forward contract or option) and the firm commitment. When a forward contract is the hedging instrument of a firm commitment, the fair value of the firm commitment is determined through reference to changes in the forward exchange rate. When an option is used, the fair value of the firm commitment is determined from changes in the spot exchange rate.

Question 37

Option used as a fair value hedge of firm commitment

Answer 37

1. Record purchase of foreign currency option as an asset 2. Adjust fair value of the option and record change in value of option as gain or loss 3. Record firm commitment as an asset at its fair value and record firm commitment gain/loss for change in the fair value of the firm commitment

Question 38

Major difference in IFRS and US GAAP for foreign currency transactions and hedges

Answer 38

GAAP: only derivative financial instruments can be used as a cash flow hedge. IFRS: Allows nonderivative financial instruments like foreign currency loans to be designated as hedging instruments in a foreign currency cash flow hedge.