CHAPTER 6
FOREIGN CURRENCY TRANSACTIONS AND
HEDGING FOREIGN EXCHANGE RISK
Chapter Outline
I. There are a variety of exchange rate arrangements in use around the world. A majority of national currencies are allowed to fluctuate in value against other currencies over time. Some currencies are pegged in terms of another currency, often the U.S. dollar.
A. The spot rate is the price at which a foreign currency can be purchased or sold today.
B. The forward rate is the price that can be locked-in today at which foreign currency can be purchased or sold at a predetermined date in the future.
C. Exchange rates can be stated as direct quotes (number of dollars per foreign currency unit) or indirect quotes (number of foreign currency units per dollar).
II. A company can enter into a forward contract with its bank to fix the price at which it can buy or sell foreign currency at a specified future date. There is no up front cost to enter into a forward contract. When it matures, the forward contract must be honored, with the company buying or selling foreign currency at the predetermined forward rate.
III. A company can purchase a foreign currency option that gives it the right, but not the obligation, to buy or sell foreign currency at a specified future date at a predetermined price (the strike price). The company purchases the option by paying an option premium. Upon maturity, the company can choose to exercise the option and buy or sell currency at the strike price, or allow the option to expire unexercised.
A. The option premium (fair value of the option) is a function of two components: intrinsic value and time value. Intrinsic value is the gain that can be realized by exercising the option immediately (the difference between the strike price and the spot rate). An option with a positive intrinsic value is “in the money.” Time value relates to the fact that as time passes and the spot rate changes, the option might become more valuable.
B. The value of a foreign currency option can be determined through the use of an option pricing formula, such as Black-Scholes.
IV. Export sales and import purchases that are denominated in a foreign currency create exposure to foreign exchange risk.
A. An increase in the value of a foreign currency will result in a foreign exchange gain on a foreign currency receivable and a foreign exchange loss on a foreign currency payable.
B. Conversely, a decrease in the value of a foreign currency will result in a foreign exchange loss on a foreign currency receivable and a foreign exchange gain on a foreign currency payable.
V. Foreign currency balances must be revalued to their current domestic currency equivalent using current exchange rates whenever financial statements are prepared. Both IAS 21 and SFAS 52 require foreign exchange gains and losses on foreign currency balances to be recognized in income in the period in which an exchange rate change occurs. This is known as the two-transaction perspective, accrual approach.
VI. Exposure to foreign exchange risk can be eliminated through hedging. Hedging involves establishing a price today at which a foreign currency receivable (or payable) in the future can be sold (or purchased) in the future.
VII. The two most popular instruments for hedging foreign exchange risk are foreign currency forward contracts and foreign currency options.
A. Forward contracts and options are derivative financial instruments; their value is derived from changes in foreign exchange rates.
B. Both IAS 39 and SFAS 133 (as amended by SFAS 138) require derivative financial instruments to be reported on the balance sheet at their fair value; as assets when fair value is positive and as liabilities when fair value is negative.
C. Hedge accounting is appropriate if the derivative is (a) used to hedge an exposure to foreign exchange risk, (b) highly effective in offsetting changes in the fair value or cash flows related to the hedged item, and (c) properly documented as a hedge. Under hedge accounting, gains and losses on the hedging instrument (changes in fair value) are reported in net income in the same period as gains and loss on the item being hedged.
VIII. The fair value of a forward contract is determined by reference to changes in the forward rate over the life of the contract, discounted to present value. The fair value of a foreign currency option is determined by reference to market price if traded on an exchange, or through use of a pricing formula if acquired in the over the counter market.
A. Changes in the fair value of a derivative financial instrument are recognized as gains and losses in net income or are deferred on the balance sheet in accumulated other comprehensive income (stockholders’ equity).
B. Under hedge accounting, gains and losses on the hedging instrument are not reported in net income until the period in which gains and loss on the item being hedged are recognized.
C. Hedge accounting is appropriate if the derivative is (a) used to hedge an exposure to foreign exchange risk, (b) highly effective in offsetting changes in the fair value or cash flows related to the hedged item, and (c) properly documented as a hedge.
IX. SFAS 133 (as amended by SFAS 138) provides guidance for hedges of (a) recognized foreign currency denominated assets and liabilities, (b) unrecognized foreign currency firm commitments, and (c) forecasted foreign currency denominated transactions. Cash flow hedge accounting can be used for all three types of hedge; fair value hedge accounting can be used only for (a) and (b).
A. Under cash flow hedge accounting for foreign currency denominated assets and liabilities, at each balance sheet date:
1. The hedged asset or liability is adjusted to fair value based on changes in the spot exchange rate, and a foreign exchange gain or loss is recognized in net income.
2. The derivative hedging instrument is adjusted to fair value (resulting in an asset or liability reported on the balance sheet), with the counterpart recognized as a change in Accumulated Other Comprehensive Income (AOCI).
3. An amount equal to the foreign exchange gain or loss on the hedged asset or liability is then transferred from AOCI to net income; the net effect is to offset any gain or loss on the hedged asset or liability.
4. An additional amount is removed from AOCI and recognized in net income to reflect (a) the current period’s amortization of the original discount or premium on the forward contract (if a forward contract is the hedging instrument) or (b) the change in the time value of the option (if an option is the hedging instrument).
B. Under fair value hedge accounting for foreign currency denominated assets and liabilities, at each balance sheet date:
1. The hedged asset or liability is adjusted to fair value based on changes in the spot exchange rate, and a foreign exchange gain or loss is recognized in net income.
2. The derivative hedging instrument is adjusted to fair value (resulting in an asset or liability reported on the balance sheet), with the counterpart recognized as a gain or loss in net income.
C. There is no entry to record a firm commitment or the derivative instrument used to hedge a firm commitment at the time the firm commitment is created. At each subsequent balance sheet date:
1. The firm commitment is reported on the balance sheet as an asset or liability at fair value, and the change in the fair value of the firm commitment is recognized as a gain or loss in net income. A decision must be made whether to measure the fair value of the firm commitment through reference to (a) changes in the spot exchange rate or (b) changes in the forward rate.
2. The derivative hedging instrument is adjusted to fair value (resulting in an asset or liability reported on the balance sheet), with the counterpart recognized as a gain or loss in net income.
D. Only cash flow hedge accounting may be used for hedges of forecasted foreign currency transactions. For hedge accounting to apply, the forecasted transaction must be probable (likely to occur). The accounting for a hedge of a forecasted transaction differs from the accounting for a hedge of a foreign currency firm commitment in two ways:
1. Unlike the accounting for a firm commitment, there is no recognition of the forecasted transaction or gains and losses on the forecasted transaction.
2. The hedging instrument (forward contract or option) is reported at fair value, but because there is no gain or loss on the forecasted transaction to offset against, changes in the fair value of the hedging instrument are not reported as gains and losses in net income. Instead they are reported in other comprehensive income. On the projected date of the forecasted transaction, the cumulative change in the fair value of the hedging instrument is transferred from accumulated other comprehensive income (balance sheet) to net income (income statement).
Answers to Questions
1. Under the two-transaction perspective, an export sale (import purchase) and the subsequent collection (payment) of cash are treated as two separate transactions to be accounted for separately. The idea is that management has made two decisions: (1) to make the export sale, and (2) to extend credit in foreign currency to the foreign customer. The income effect from each of these decisions should be reported separately.
2. Foreign currency receivables resulting from export sales are revalued at the end of accounting periods using the current spot rate. An increase in the value of a receivable will be offset by reporting a foreign exchange gain in net income, and a decrease will be offset by a foreign exchange loss. Foreign exchange gains and losses are accrued even though they have not yet been realized.
3. Foreign exchange gains and losses are created by two factors: having foreign currency exposures (foreign currency receivables and payables) and changes in exchange rates. Appreciation of the foreign currency will generate foreign exchange gains on receivables and foreign exchange losses on payables. Depreciation of the foreign currency will generate foreign exchange losses on receivables and foreign exchange gains on payables.
4. Hedging is the process of eliminating exposure to foreign exchange risk so as to avoid potential losses from fluctuations in exchange rates. In addition to avoiding possible losses, companies hedge foreign currency transactions and commitments so as to introduce an element of certainty into the future cash flows resulting from foreign currency activities. Hedging involves establishing a price today at which foreign currency can be sold or purchased at a future date.
5. A party to a foreign currency forward contract is obligated to deliver one currency in exchange for another at a specified future date, whereas the owner of a foreign currency option can choose whether to exercise the option and exchange one currency for another or not.
6. Hedges of foreign currency denominated assets and liabilities are not entered into until a foreign currency transaction (import purchase or export sale) has taken place. Hedges of firm commitments are made when a purchase order is placed or a sales order is received, before a transaction has taken place. Hedges of forecasted transactions are made at the time a future foreign currency purchase or sale can be anticipated, even before an order has been placed or received.
7. Foreign currency options have an advantage over forward contracts in that the holder of the option can choose not to exercise if the future spot rate turns out to be more advantageous. Forward contracts, on the other hand, can lock a company into an unnecessary loss (or a reduced gain). The disadvantage associated with foreign currency options is that a premium must be paid up front even though the option might never be exercised.
8. SFAS 133 requires an enterprise to recognize all derivative financial instruments as assets or liabilities on the balance sheet and measure them at fair value.
9. The fair value of a foreign currency forward contract is determined by reference to changes in the forward rate over the life of the contract, discounted to the present value. Three pieces of information are needed to determine the fair value of a forward contract at any point in time during its life: (a) the contracted forward rate when the forward contract is entered into, (b) the current forward rate for a contract that matures on the same date as the forward contract entered into, and (c) a discount rate; typically, the company’s incremental borrowing rate.
The manner in which the fair value of a foreign currency option is determined depends on whether the option is traded on an exchange or has been acquired in the over the counter market. The fair value of an exchange-traded foreign currency option is its current market price quoted on the exchange. For over the counter options, fair value can be determined by obtaining a price quote from an option dealer (such as a bank). If dealer price quotes are unavailable, the company can estimate the value of an option using the modified Black-Scholes option pricing model. Regardless of who does the calculation, principles similar to those in the Black-Scholes pricing model will be used in determining the value of the option.
10. Hedge accounting is defined as recognition of gains and losses on the hedging instrument in the same period as the recognition of gains and losses on the underlying hedged asset or liability (or firm commitment).
11. For hedge accounting to apply, the forecasted transaction must be probable (likely to occur), the hedge must be highly effective in offsetting fluctuations in the cash flow associated with the foreign currency risk, and the hedging relationship must be properly documented.
12. In both cases, (1) sales revenue (or the cost of the item purchased) is determined using the spot rate at the date of sale (or purchase), and (2) the hedged asset or liability is adjusted to fair value based on changes in the spot exchange rate with a foreign exchange gain or loss is recognized in net income.
For a cash flow hedge, the derivative hedging instrument is adjusted to fair value (resulting in an asset or liability reported on the balance sheet), with the counterpart recognized as a change in Accumulated Other Comprehensive Income (AOCI). An amount equal to the foreign exchange gain or loss on the hedged asset or liability is then transferred from AOCI to net income; the net effect is to offset any gain or loss on the hedged asset or liability. An additional amount is removed from AOCI and recognized in net income to reflect (a) the current period’s amortization of the original discount or premium on the forward contract (if a forward contract is the hedging instrument) or (b) the change in the time value of the option (if an option is the hedging instrument).
For a fair value hedge, the derivative hedging instrument is adjusted to fair value (resulting in an asset or liability reported on the balance sheet), with the counterpart recognized as a gain or loss in net income. The discount or premium on a forward contract is not allocated to net income. The change in the time value of an option is not recognized in net income.
13. For a fair value hedge of a foreign currency asset or liability (1) sales revenue (cost of purchases) is recognized at the spot rate at the date of sale (purchase) and (2) the hedged asset or liability is adjusted to fair value based on changes in the spot exchange rate with a foreign exchange gain or loss recognized in net income. The forward contract is adjusted to fair value based on changes in the forward rate (resulting in an asset or liability reported on the balance sheet), with the counterpart recognized as a gain or loss in net income. The foreign exchange gain (loss) and the forward contract loss (gain) are likely to be of different amounts resulting in a net gain or loss reported in net income.
For a fair value hedge of a firm commitment, there is no hedged asset or liability to account for. The forward contract is adjusted to fair value based on changes in the forward rate (resulting in an asset or liability reported on the balance sheet), with a gain or loss recognized in net income. The firm commitment is also adjusted to fair value based on changes in the forward rate (resulting in a liability or asset reported on the balance sheet), and a gain or loss on firm commitment is recognized in net income. The firm commitment gain (loss) offsets the forward contract loss (gain) resulting in zero impact on net income. Sales revenue (cost of purchases) is recognized at the spot rate at the date of sale (purchase). The firm commitment account is closed as an adjustment to net income in the period in which the hedged item affects net income.
14. For a cash flow hedge of a foreign currency asset or liability (1) sales revenue (cost of purchases) is recognized at the spot rate at the date of sale (purchase) and (2) the hedged asset or liability is adjusted to fair value based on changes in the spot exchange rate with a foreign exchange gain or loss recognized in net income. The forward contract is adjusted to fair value (resulting in an asset or liability reported on the balance sheet), with the counterpart recognized as a change in Accumulated Other Comprehensive Income (AOCI). An amount equal to the foreign exchange gain or loss on the hedged asset or liability is then transferred from AOCI to net income; the net effect is to offset any gain or loss on the hedged asset or liability. An additional amount is removed from AOCI and recognized in net income to reflect the current period’s allocation of the discount or premium on the forward contract.
For a hedge of a forecasted transaction, the forward contract is adjusted to fair value (resulting in an asset or liability reported on the balance sheet), with the counterpart recognized as a change in Accumulated Other Comprehensive Income (AOCI). Because there is no foreign currency asset or liability, there is no transfer from AOCI to net income to offset any gain or loss on the asset or liability. The current period’s allocation of the forward contract discount or premium is recognized in net income with the counterpart reflected in AOCI. Sales revenue (cost of purchases) is recognized at the spot rate at the date of sale (purchase). The amount accumulated in AOCI related to the hedge is closed as an adjustment to net income in the period in which the forecasted transaction was anticipated to occur.
15. In accounting for a fair value hedge, the change in the fair value of the foreign currency option is reported as a gain or loss in net income. In accounting for a cash flow hedge, the change in the entire fair value of the option is first reported in other comprehensive income, and then the change in the time value of the option is reported as an expense in net income.
16. The accounting for a foreign currency borrowing involves keeping track of two foreign currency payables–the note payable and interest payable. As both the face value of the borrowing and accrued interest represent foreign currency liabilities, both are exposed to foreign exchange risk and can give rise to foreign currency gains and losses.
Solutions to Exercises and Problems
1. C An import purchase causes a foreign currency payable to be carried on the books. If the foreign currency depreciates, the dollar value of the foreign currency payable decreases, yielding a foreign exchange gain.
2. D A foreign currency receivable will generate a foreign exchange gain when the foreign currency increases in dollar value. A foreign currency payable will generate a foreign exchange gain when the foreign currency decreases in dollar value. Hence, the correct combination is yen (increase) and real (decrease).
3. D The forward contract must be reported at its fair value discounted for two months at 12% [($.084 – $.074) x 1,000,000 = $10,000 x .9803 = $9,803.00].
4. C The 100,000 shekel receivable has changed in dollar value from $24,000 at 12/1/Y1 to $22,000 at 12/31/Y1. The shekel receivable will be written down by $2,000 and a foreign exchange loss will be reported in Year 1 income.
5. B The nominal value of the forward contract on December 31, Year 1 is a positive $3,000, the difference between the amount to be received from the forward contract actually entered into, $23,000 ($.23 x 100,000 shekels), and the amount that could be received by entering into a forward contract on December 31, Year 1 that matures on January 15, Year 2, $20,000 ($.10 x 100,000 shekels). The fair value of the forward contract is the present value of $3,000 discounted for two months ($3,000 x .9706 = $2,911.80). On December 31, Year 1, Reiter Corp. will recognize a $2,911.80 gain on the forward contract and a foreign exchange loss of $2,000 on the shekel receivable. The net impact on Year 1 income is + $911.80.
The easiest way to solve problems 6, 7 and 8 is to prepare journal entries for the option fair value hedge and the firm commitment. The journal entries are as follows:
9/1/Y1
Foreign Currency Option $1,700
Cash $1,700
12/31/Y1
Foreign Currency Option $1,100
Gain on Foreign Currency Option $1,100
Loss on Firm Commitment $1,960.60
Firm Commitment $1,960.60
[($.73 – $.75) x 100,000 = $2,000 x .9803 = $1,960.60]
Net impact on Year 1 net income: Gain on Foreign Currency Option $1,100.00
Loss on Firm Commitment (1,960.60)
$(860.60)
6. B
3/1/Y2
Foreign Currency Option $1,200
Gain on Foreign Currency Option $1,200
Loss on Firm Commitment $2,039.40
Firm Commitment $2,039.40
[($.71 – $.75) x 100,000 = $4,000 – $1,960.60 = $2,039.40]
Foreign Currency (C$) $71,000
Sales $71,000
Cash $75,000
Foreign Currency (C$) $71,000
Foreign Currency Option 4,000
Firm Commitment $4,000
Adjustment to Net Income $4,000
Net impact on Year 2 net income: Gain on Foreign Currency Option $ 1,200.00
Loss on Firm Commitment (2,039.40)
Sales 71,000.00
Adjustment to Net Income 4,000.00
$74,160.60
7. C
8. D Net cash inflow with the option: $75,000 – 1,700 = $73,300
Net cash inflow without the option: C$100,000 x .71 = 71,000
Increase in net cash flow $ 2,300
The easiest way to solve problems 9 and 10 is to prepare journal entries for the option cash flow hedge of a forecasted transaction. The journal entries are as follows:
11/1/Y1
Foreign Currency Option $1,200
Cash $1,200
12/31/Y1
Option Expense $300
Foreign Currency Option $300
(The option has no intrinsic value at 12/31/Y1 so the entire change in fair value is due to a change in time value — $1,200 – $900 = $300 decrease in time value. The decrease in time value of the option is recognized as an expense in net income.)
9. C Option Expense decreases net income by $300.
2/1/Y2
Option Expense $ 900
Foreign Currency Option 1,100
Accumulated Other Comprehensive Income (AOCI) $2,000
(Record expense for the decrease in time value of the option — $900 – $0; write-up option to fair value ($.35 – $.36) x 200,000 = $2,000 – $900 = $1,100)
Foreign Currency (ARS) [200,000 x $.36] $72,000
Cash [200,000 x $.35] $70,000
Foreign Currency Option 2,000
Parts Inventory (Cost-of-Goods-Sold) $72,000
Foreign Currency (ARS) $72,000
Accumulated Other Comprehensive Income (AOCI) $2,000
Adjustment to Net Income $2,000
Net impact on Year 2 net income: Option Expense $ (900)
Cost-of-Goods-Sold (72,000)
Adjustment to Net Income 2,000
Decrease in Net Income $ (70,900)
10. B
11. Garden Grove Corporation – Foreign Currency Sale/Receivable
9/15/Y1 Accounts receivable (FCU) [100,000 x $.40] $40,000
Sales $40,000
9/30/Y1 Accounts receivable (FCU) [100,000 x ($.42-$.40)] $2,000
Foreign exchange Gain $2,000
10/15/Y1 Foreign exchange loss $5,000
Accounts receivable (FCU) [100,000 x ($.37-$.42)] $5,000
Cash $37,000
Accounts receivable (FCU) $37,000
12. El Primero Company – Foreign Currency Purchase/Payable
12/1/Y1 Inventory $34,800
Accounts payable (coronas) [40,000 x $.87] $34,800
12/31/Y1 Accounts payable (coronas) [40,000 x ($.82-$.87)] $2,000
Foreign exchange gain $2,000
1/28/Y1 Foreign exchange loss $3,600
Accounts payable (coronas) [40,000 x ($.91-$.82)] $3,600
Accounts payable (coronas) $36,400
Cash $36,400
13. Lester Company – Foreign Currency Borrowing
9/30/Y1 Cash $200,000
Note payable (markka) [1,000,000 x $.20] $200,000
(To record the note and conversion of 1 million markkas into $ at the spot rate.)
12/31/Y1 Interest expense $1,050
Interest payable (markka) $1,050
[1,000,000 x 2% x 3/12 = 5,000 markkas x $.21 spot rate]
(To accrue interest for the period 9/30 – 12/31/Y1.)
Foreign exchange loss $10,000
Note payable (markka) [1 mn x ($.21 – $.20)] $10,000
(To revalue the note payable at the spot rate of $.21 and record a foreign exchange loss.)
9/30/Y2 Interest expense [15,000 markkas x $.23] $3,450
Interest payable (markka) 1,050
Foreign exchange loss [5,000 markkas x ($.23- $.21)] 100
Cash [20,000 markkas x $.23] $4,600
(To record the first annual interest payment, record interest expense for the period 1/1 – 9/30/Y2, and record a foreign exchange loss on the interest payable accrued at 12/31/Y1.)
12/31/Y2 Interest expense $1,200
Interest payable (markka) [5,000 markkas x $.24] $1,200
(To accrue interest for the period 9/30 – 12/31/Y2.)
Foreign exchange loss $30,000
Note payable (markka) [1 mn x ($.24 – $.21)] $30,000
(To revalue the note payable at the spot rate of $.24 and record a foreign exchange loss.)
9/30/Y3 Interest expense [15,000 markkas x $.27] $4,050
Interest payable (markka) 1,200
Foreign exchange loss [5,000 markkas x ($.27 – $.24)] 150
Cash [20,000 markkas x $.27] $5,400
(To record the second annual interest payment, record interest expense for the period 1/1 – 9/30/Y3, and record a foreign exchange loss on the interest payable accrued at 12/31/Y2.)
Note payable (markka) $240,000
Foreign exchange loss 30,000
Cash [1 mn markkas x $.27] $270,000
(To record payment of the 1 million markka note.)
The effective cost of borrowing can be determined by considering the total interest expense and foreign exchange losses related to the loan and comparing this with the amount borrowed:
Year 1
Interest expense $1,050
Foreign exchange loss 10,000
Total $11,050 / $200,000 = 5.525% for 3 months
= 22.1% for 12 months
Year 2
Interest expense $4,650
Foreign exchange losses 30,100
Total $34,750 / $200,000 = 17.375% for 12 months
Year 3
Interest expense $4,050
Foreign exchange losses 30,150
Total $34,200 / $200,000 = 17.1% for 9 months
= 22.8% for 12 months
= 36.5% for 12 months
Because of appreciation in the value of the markka, effective annual borrowing costs range from 17.4% – 22.8%.
The net cash flow from this borrowing is:
Cash outflows:
Interest ($4,600 + $5,400) $10,000
Principal 270,000
$280,500
Cash inflow:
Borrowing (200,000)
Net cash outflow $80,000
Ignoring compounding, this results in an effective borrowing cost of approximately 20.0% per year [$80,000 / $200,000 = 40.0% over two years / 2 years = 20.0% per year].
14. Budvar Company
a. Forward Contract Cash Flow Hedge of Foreign Currency Receivable
12/1/Y1 Accounts receivable (crowns) [20,000 x $1.00] $20,000
Sales $20,000
No entry for the forward contract.
12/31/Y1 Accounts receivable (crowns) [20,000 x ($1.05-$1.00)] $1,000
Foreign exchange gain $1,000
Loss on forward contract $1,000
AOCI $1,000
AOCI [20,000 x ($1.04-$1.10) = $1,200 x .9803 = $1,176.36] $1,176.36
Forward contract $1,176.36
AOCI [20,000 x ($1.04-$1.00) = $800 x 1/3 = $266.67] $266.67
Premium revenue $266.67
Impact on Year 1 income:
Sales $20,000.00
Foreign exchange gain 1,000.00
Loss on forward contract (1,000.00)
Premium revenue 266.67
Total $20,266.67
3/1/Y2 Accounts receivable (crowns) [20,000 x ($1.12-$1.05)] $1,400
Foreign exchange gain $1,400
Loss on forward contract $1,400
AOCI $1,400
AOCI $423.64
Forward contract [20,000 x ($1.12-$1.04) = $1,600 – 1,176.36] $423.64
AOCI [$800 x 2/3 = $533.33] $533.33
Premium revenue $533.33
Foreign currency (crown) [20,000 x $1.12] $22,400
Accounts receivable (crown) $22,400
Cash [20,000 x $1.04] $20,800
Forward contract 1,600
Foreign currency (crown) $22,400
Impact on Year 2 income:
Foreign exchange gain $1,400.00
Loss on forward contract (1,400.00)
Premium revenue 533.33
Total $ 533.33
Impact on net income over both periods: $20,266.67 + $533.33 = $20,800; equal to cash inflow.
b. Forward Contract Fair Value Hedge of Foreign Currency Receivable
12/1/Y1 Accounts receivable (crown) [20,000 x $1.00] $20,000
Sales $20,000
No entry for the forward contract.
12/31/Y1 Accounts receivable (crown) [20,000 x ($1.05-$1.00)] $1,000
Foreign exchange gain $1,000
Loss on forward contract $1,176.36
Forward contract [20,000 x ($1.04-$1.10) = $1,200 x .9803 = $1,176.36] $1,176.36
Impact on Year 1 income:
Sales $20,000.00
Foreign exchange gain 1,000.00
Loss on forward contract (1,176.36)
Total $19,823.64
3/1/Y2 Accounts receivable (crown) [20,000 x ($1.12-$1.05)] $1,400
Foreign exchange gain $1,400
Loss on forward contract $423.64
Forward contract [20,000 x ($1.12-$1.04) = $1,600 – 1,176.36] $423.64
Foreign currency (crown) [20,000 x $1.12] $22,400
Accounts receivable (K) $22,400
Cash [20,000 x $1.04] $20,800
Forward contract 1,600
Foreign currency (K) $22,400
Impact on Year 2 income:
Foreign exchange gain $1,400.00
Loss on forward contract (423.64)
Total $ 976.36
Impact on net income over both periods: $19,823.64 + $976.36 = $20,800; equal to cash inflow.
15. Budvar Company (Second Problem)
a. Forward Contract Cash Flow Hedge of Foreign Currency Payable
12/1/Y1 Inventory $20,000
Accounts payable (crown) [20,000 x $1.00] $20,000
No entry for the forward contract.
12/31/Y1 Foreign exchange loss $1,000
Accounts receivable (crown) [20,000 x ($1.05-$1.00)] $1,000
AOCI $1,000
Gain on forward contract $1,000
Forward contract $1,176.36
AOCI [20,000 x ($1.04-$1.10) = $1,200 x .9803 = $1,176.36] $1,176.36
Premium expense $266.67
AOCI [20,000 x ($1.04-$1.00) = $800 x 1/3 = $266.67] $266.67
Impact on Year 1 income:
Foreign exchange loss $(1,000.00)
Gain on forward contract 1,000.00
Premium expense (266.67)
Total $ (266.67)
3/1/Y2 Foreign exchange loss $1,400
Accounts payable (crown) [20,000 x ($1.12-$1.05)] $1,400
AOCI $1,400
Gain on forward contract $1,400
Forward contract [20,000 x ($1.12-$1.04) = $1,600 – 1,176.36] $423.64
AOCI $423.64
Premium expense $533.33
AOCI [$800 x 2/3 = $533.33] $533.33
Foreign currency (crown) [20,000 x $1.12] $22,400
Cash [20,000 x $1.04] $20,800
Forward contract 1,600
Accounts payable (crown) $20,800
Foreign currency (crown) $20,800
3/15/Y2 Cost of goods sold $20,000
Inventory $20,000
Impact on Year 2 income:
Foreign exchange loss $(1,400.00)
Gain on forward contract 1,400.00
Premium expense (533.33)
Cost of goods sold (20,000.00)
Total $(20,533.33)
Impact on net income over both periods: $(266.67) + ($20,533.33) = $20,800; equal to cash outflow.
b. Forward Contract Fair Value Hedge of Foreign Currency Payable
12/1/Y1 Inventory $20,000
Accounts payable (crown) [20,000 x $1.00] $20,000
No entry for the forward contract.
12/31/Y1 Foreign exchange loss $1,000
Accounts receivable (crown) [20,000 x ($1.05-$1.00)] $1,000
Forward contract $1,176.36
Gain on forward contract $1,176.36
[20,000 x ($1.04-$1.10) = $1,200 x .9803 = $1,176.36]
Impact on Year 1 income:
Foreign exchange loss $(1,000.00)
Gain on forward contract 1,176.36
Total $ 176.36
3/1/Y2 Foreign exchange loss $1,400
Accounts payable (crown) [20,000 x ($1.12-$1.05)] $1,400
Forward contract $423.64
Gain on forward contract $423.64
[20,000 x ($1.12-$1.04) = $1,600 – 1,176.36]
Foreign currency (crown) [20,000 x $1.12] $22,400
Cash [20,000 x $1.04] $20,800
Forward contract 1,600
Accounts payable (crown) $20,800
Foreign currency (crown) $20,800
3/15/Y2 Cost of goods sold $20,000
Inventory $20,000
Impact on Year 2 income:
Foreign exchange loss $(1,400.00)
Gain on forward contract 423.64
Cost of goods sold (20,000.00)
Total $(20,976.36)
Impact on net income over both periods: $176.36 + ($20,976.36) = $20,800; equal to cash outflow.
16. Alexandria Company – Forward Contract Cash Flow Hedge of Foreign Currency Denominated Asset
Account Receivable (franc) Forward Forward Contract
Spot U.S. Dollar Change in U.S. Rate to Change in
Date Rate Value Dollar Value 4/30/Y2 Fair Value Fair Value
11/01/Y1 $.23 $23,000 – $.22 $0 –
12/31/Y1 $.20 $20,000 -$3,000 $.18 $3,8441 +$3,844
4/30/Y2 $.19 $19,000 -$1,000 N/A $3,0002 – $ 844
1 $22,000 – $18,000 = $(4,000) x .961 = $3,844; where .961 is the present value factor for four months at an annual interest rate of 12% (1% per month) calculated as 1/1.014.
2 $22,000 – $19,000 = $3,000.
Year 1 Journal Entries
11/01/Y1 Accounts Receivable (franc) $23,000
Sales $23,000
12/31/Y1 Foreign Exchange Loss $3,000
Accounts Receivable (franc) $3,000
Accumulated Other Comprehensive Income (AOCI) $3,000
Gain on Forward Contract $3,000
Forward Contract $3,844
Accumulated Other Comprehensive Income (AOCI) $3,844
Discount Expense $333.33
Accumulated Other Comprehensive Income (AOCI) $333.33
[($.22-$.23) x 100,000 = $1,000 x 1/3 = $333.33]
The impact on net income for the year Year 1 is:
Sales $23,000.00
Foreign Exchange Loss (3,000.00)
Gain on Forward Contract 3,000.00
Net gain (loss) 0.00
Discount Expense (333.33)
Impact on net income $22,666.67
Year 2 Journal Entries
4/30/Y2 Foreign Exchange Loss $1,000
Accounts Receivable (franc) $1,000
Accumulated Other Comprehensive Income (AOCI) $1,000
Gain on Forward Contract $1,000
Accumulated Other Comprehensive Income (AOCI) $844
Forward Contract $844
Discount Expense $666.67
Accumulated Other Comprehensive Income (AOCI) $666.67
Foreign Currency (franc) $19,000
Accounts Receivable (franc) $19,000
Cash $22,000
Foreign Currency (franc) $19,000
Forward Contract 3,000
The impact on net income for Year 2 is:
Foreign Exchange Loss $(1,000.00)
Gain on Forward Contract 1,000.00
Net gain (loss) 0.00
Discount Expense (666.67)
Impact on net income $(666.67)
17. Artco Inc. – Forward Contract Fair Value Hedge of Net Foreign Currency Denominated Asset
Account Receivable (Payable) (ricas) Forward Forward Contract
Change in U.S. Rate to Change in
Date U.S. Dollar Value Dollar Value 3/1/Y2 Fair Value Fair Value
11/30/Y1 $52,000 ($39,000) – $.12 $0 –
12/31/Y1 $40,000 ($30,000) -$12,000 (-$9,000) $.08 $3,960.401 +$3,960.40
1/31/Y2 $36,000 ($27,000) -$ 4,000 (-$3,000) N/A $3,000.002 – $960.40
1 $8,000 – $12,000 = $(4,000) x .9901 = $3,960.40; where .9901 is the present value factor for one month at an annual interest rate of 12% (1% per month) calculated as 1/1.01.
2 $12,000 – $9,000 = $3,000.
Year 1 Journal Entries
11/30/Y1 Accounts Receivable (ricas) [$.13 x 400,000] $52,000
Sales $52,000
Supplies Expense $39,000
Accounts Payable (ricas) [$.13 x 300,000] $39,000
There is no formal entry for the forward contract.
12/31/Y1
Foreign Exchange Loss $12,000
Accounts Receivable (ricas) $12,000
Account Payable (ricas) $9,000
Foreign Exchange Gain $9,000
Forward Contract $3,960.40
Gain on Forward Contract $3,960.40
The impact on net income for Year 1 is:
Sales $52,000.00
Supplies Expense (39,000.00)
Foreign Exchange Loss (12,000.00)
Foreign Exchange Gain 9,000.00
Gain on Forward Contract 3,960.40
Net gain (loss) 960.40
Impact on net income $13,960.40
Year 2 Journal Entries
1/31/Y2 Foreign Exchange Loss $4,000
Accounts Receivable (ricas) $4,000
Account Payable (ricas) $3,000
Foreign Exchange Gain $3,000
Loss on Forward Contract $960.40
Forward Contract $960.40
Foreign Currency (ricas) $36,000
Accounts Receivable (ricas) $36,000
Accounts Payable (ricas) $27,000
Foreign Currency (ricas) $27,000
Cash $12,000
Foreign Currency (ricas) [$36,000 – $27,000] $9,000
Forward Contract 3,000
The impact on net income for the year Year 2 is:
Foreign Exchange Loss $(4,000.00)
Foreign Exchange Gain 3,000.00
Loss on Forward Contract (960.40)
Impact on net income $(1,960.40)
The net effect on the balance sheet is an increase in cash of $12,000 with a corresponding increase in retained earnings of $12,000 ($13,960.40 – $1,960.40).
18. Butterworth Company
a. Forward Contract Fair Value Hedge of Foreign Currency Receivable
10/01/Y1 Accounts Receivable (rupees) [$.069 x 100,000] $6,900
Sales $6,900
There is no formal entry for the forward contract.
12/31/Y1 Account Receivable (rupees) $200
Foreign Exchange Gain [($.071 – $.069) x 100,000] $200
Loss on Forward Contract $891.09
Forward Contract $891.09
[($.074 – $.065) x 100,000 = $ 900 x .9901 = $ 891.09]
1/31/Y2 Accounts Receivable (rupees) $100
Foreign Exchange Gain [($.072 – $.071) x 100,000] $100
Forward Contract $191.09
Gain on Forward Contract $191.09
[($.072 – $.065) x 100,000 = $ 700 loss – $891.09 = $ 191.09 gain]
Foreign Currency (rupees) [$.072 x 100,000] $7,200
Accounts Receivable (rupees) $7,200
Cash $6,500
Forward Contract 700
Foreign Currency (rupees) $7,200
The impact on net income:
Sale $6,900.00
Foreign Exchange Gain 300.00
Loss on Forward Contract (891.09)
Gain on Forward Contract 191.09
Impact on net income $6,500.00 = Cash Inflow
b. Forward Contract Fair Value Hedge of Foreign Currency Firm Sales Commitment
10/01/Y1 There is no entry to record either the sales agreement or the forward contract as both are executory contracts.
12/31/Y1 Loss on Forward Contract $891.09
Forward Contract $891.09
Firm Commitment $891.09
Gain on Firm Commitment $891.09
1/31/Y2 Forward Contract $191.09
Gain on Forward Contract $191.09
Loss on Firm Commitment $191.09
Firm Commitment $191.09
Foreign Currency (rupees) $7,200
Sales $7,200
Cash $6,500
Forward contract 700
Foreign Currency (LCU) $7,200
Adjustment to Net Income $700
Firm Commitment $700
Impact on Net Income:
Sales $7,200
Net loss on Forward Contract (700)
Net gain on Firm Commitment 700
Adjustment for Net Income (700)
$6,500 = Cash Inflow
19. Huntington Corporation – Forward Contract Fair Value Hedge of a Foreign Currency Firm Purchase Commitment
Forward Forward Contract Firm Commitment
Rate to Change in Change in
Date 10/31/Y1 Fair Value Fair Value Fair Value Fair Value
8/1/Y1 $1.310 $0 – $0 –
9/30/Y1 $1.325 $1,485.151 + $1,485.15 $(1,485.15)1 – $1,485.15
10/31/Y1 $1.320 (spot) $1,0002 – $ 485.15 $(1,000)2 + $ 485.15
1 ($132,500 – $131,000) = $1,500 x .9901 = $1,485.15; where .9901 is the present value factor for one month at an annual interest rate of 12% (1% per month) calculated as 1/1.01.
2 ($132,000 – $131,000) = $1,000.
8/1/Y1 There is no entry to record either the sales agreement or the forward contract as both are executory contracts.
9/30/Y1 Forward Contract $1,485.15
Gain on Forward Contract $1,485.15
Loss on Firm Commitment $1,485.15
Firm Commitment $1,485.15
10/31/Y1 Loss on Forward Contract $485.15
Forward Contract $485.15
Firm Commitment $485.15
Gain on Firm Commitment $485.15
Foreign Currency (dinars) $132,000
Cash $131,000
Forward Contract 1,000
Inventory $132,000
Foreign Currency $132,000
Firm Commitment $1,000
Adjustment to Net Income $1,000
12/31/Y1 Cost of goods sold $132,000
Inventory $132,000
The net cash outflow is $131,000. The net impact on net income is negative $131,000:
Net gain (loss) on forward contract $1,000
Net gain (loss) on firm commitment (1,000)
Cost-of-goods-sold (132,000)
Adjustment to net income 1,000
Net impact on net income $(131,000)
20. Tsanumis Corporation – Option Fair Value Hedge of a Foreign Currency Firm Sale Commitment
Firm Commitment Option Foreign Currency Option
Spot Change in Premium Change in
Date Rate Fair Value Fair Value for 9/1/Y1 Fair Value Fair Value
6/1/Y1 $1.00 – – $0.010 $10,000 –
6/30/Y1 $0.99 $( 9,803)1 – $ 9,803 $0.015 $15,000 + $5,000
9/1/Y1 $0.97 $(30,000)2 – $20,197 N/A $30,000 + $15,000
1 $990,000 – $1,00,000 = $(10,000) x .9803 = $(9,803), where .9803 is the present value factor for two months at an annual interest rate of 12% (1% per month) calculated as 1/1.012.
2 $970,000 – $1,000,000 = $(30,000).
6/1/Y1 Foreign Currency Option [$.01 x 1,000,000] $10,000
Cash $10,000
There is no entry to record the sales agreement because it is an executory contract.
6/30/Y1 Loss on Firm Commitment $9,803
Firm Commitment $9,803
Foreign Currency Option [($.015 – $.01) x 1,000,000] $5,000
Gain on Foreign Currency Option $5,000
The impact on net income for the second quarter Year 1 is:
Loss on Firm Commitment $(9,803.00)
Gain on Foreign Currency Option 5,000.00
Impact on net income $(4,803.00)
9/1/Y1 Loss on Firm Commitment $20,197
Firm Commitment $20,197
Foreign Currency Option $15,000
Gain on Foreign Currency Option $15,000
Foreign Currency (€) $970,000
Sales $970,000
Cash $1,000,000
Foreign Currency (€) $970,000
Foreign Currency Option 30,000
Firm Commitment $30,000
Adjustment to Net Income $30,000
The impact on Year 1 net income is:
Sales $970,000
Net Loss on Firm Commitment (30,000)
Net Gain on Foreign Currency Option 20,000
Adjustment to Net Income 30,000
Impact on net income $990,000
The net cash inflow resulting from the sale is: $1,000,000 – $10,000 = $990,000.
21. Zermatt Company – Option Fair Value Hedge of a Foreign Currency Firm Purchase Commitment
Firm Commitment Option Foreign Currency Option
Spot Change in Premium Change in
Date Rate Fair Value Fair Value for 12/20 Fair Value Fair Value
11/20 $.80 – – $.008 $800 –
a) 12/20 $.83 $(3,000)1 – $3,000 $.030 $3,000 + $2,200
b) 12/20 $.78 $2,0002 + $2,000 $.000 $0 – $800
1 $80,000 – $83,000 = $(3,000).
2 $80,000 – $78,000 = $2,000.
a. The option strike price ($.80) is less than the spot rate ($.83) on December 20, the date the parts are to be paid for. Therefore, Zermatt will exercise its option. The journal entries are as follows:
11/20 Foreign Currency Option $800
Cash [$.80 x 100,000 francs] $400
There is no entry to record the sales agreement as it is an executory contract.
12/20 Loss on Firm Commitment $3,000
Firm Commitment $3,000
Foreign Currency Option $2,200
Gain on Foreign Currency Option $2,200
Foreign Currency (francs) $83,000
Cash $80,000
Foreign Currency Option 3,000
Parts Inventory $83,000
Foreign Currency (francs) $83,000
Firm Commitment $3,000
Adjustment to Net Income $3,000
(Note that this last entry is not made until the period when the parts inventory affects net income through cost of goods sold.)
b. The option strike price ($.80) is greater than the spot rate ($.78) on December 20, the date the parts are to be paid for. Therefore, Zermatt will allow the option to expire unexercised. Foreign currency will be acquired at the spot rate on December 20. The journal entries are as follows:
11/20 Foreign Currency Option $800
Cash $800
There is no entry to record the sales agreement because it is an executory contract.
12/20 Firm Commitment $2,000
Gain on Firm Commitment $2,000
Loss on Foreign Currency Option $800
Foreign Currency Option $800
Foreign Currency (francs) $78,000
Cash $78,000
Parts Inventory $78,000
Foreign Currency (francs) $78,000
Adjustment to Net Income $2,000
Firm Commitment $2,000
(Note that this last entry is not made until the period when the parts inventory affects net income through cost of goods sold.)
22. Garnier Corporation – Option Cash Flow Hedge of Forecasted Transaction
Option
Date Fair Value Intrinsic Value Time Value Change in Time Value
12/15/Y1 $5,000 -0- $5,000 —
12/31/Y1 $12,000 $10,000 $2,000 – $3,000
3/15/Y2 $20,000 $20,000 -0- – $2,000
12/15/Y1 Foreign currency option $5,000
Cash [1 million lire x $.002] $5,000
No journal entry related to the forecasted transaction.
12/31/Y1 Foreign currency option $7,000
AOCI $7,000
To recognize the increase in the value of the foreign currency option with a corresponding credit to AOCI.
Option expense $3,000
AOCI $3,000
To recognize the change in the time value of the option as an expense with a corresponding credit to AOCI.
3/15/Y2 Foreign currency option $8,000
AOCI $8,000
To recognize the increase in the value of the foreign currency option with a corresponding credit to AOCI.
Option expense $2,000
AOCI $2,000
To recognize the decrease in the time value of the option as an expense with a corresponding credit to AOCI.
Foreign currency (lire) $130,000
Sales revenue $130,000
To record the sale and receipt of 1 million lire from the customer at the spot rate.
Cash $150,000
Foreign currency option 20,000
Foreign currency (lire) $130,000
To record exercise of the foreign currency option at the strike price of $.15 and close out the foreign currency option account.
AOCI $20,000
Adjustment to Net Income $20,000
To transfer the amount accumulated in AOCI as an adjustment to net income in the period in which the forecasted transaction occurs.
Impact on net income: Year 1 – Option expense $ (3,000)
Year 2 – Option expense (2,000)
Sales revenue 130,000)
Adjustment to net income 20,000
$145,000
Net cash inflow from export sale: $145,000 = ($150,000 – $5,000)
CASE 1: Zorba Company
1. Unhedged Foreign Currency Liability
12/1/Y1 Inventory $50,000
Account Payable (euro) $50,000
12/31/Y1 Foreign Exchange Loss $5,000
Account Payable (euro) $5,000
1/31/Y2 Foreign Exchange Loss $2,500
Account Payable (euro) $2,500
Foreign Currency (euro) $57,500
Cash $57,500
Account Payable (euro) $57,500
Foreign Currency (euro) $57,500
CASE 1: Zorba Company (continued)
2. Forward Contract Fair Value Hedge of a Recognized Foreign Currency Liability
Accounts Payable (€) Forward Forward Contract
Spot U.S. Dollar Change in U.S. Rate to Change in
Date Rate Value Dollar Value 10/31/Y1 Fair Value Fair Value
12/1/Y1 $1.00 $50,000 – $1.08 $0 –
12/31/Y1 $1.10 $55,000 +$5,000 $1.17 $4,455.451 +$4,455.45
1/31/Y2 $1.15 $57,500 +$2,500 $1.15 $3,500.002 – $ 955.45
1 $54,000 – $58,500 = $4,500 x .9901 = $4,455; where .9901 is the present value factor for one month at an annual interest rate of 12% (1% per month) calculated as 1/1.01.
2 $57,500 – $54,000 = $3,500.
12/1/Y1 Inventory $50,000
Accounts Payable (euro) $50,000
There is no formal entry for the forward contract.
12/31/Y1 Foreign Exchange Loss $5,000
Accounts Payable (euro) $5,000
Forward Contract $4,455.45
Gain on Forward Contract $4,455.45
1/31/Y2 Foreign Exchange Loss $2,500
Accounts Payable (euro) $2,500
Loss on Forward Contract $955.45
Forward Contract $955.45
Foreign Currency (euro) $57,500
Cash $54,000
Forward Contract 3,500
Accounts Payable (euro) $57,500
Foreign Currency (euro) $57,500
CASE 1: Zorba Company (continued)
3. Forward Contract Fair Value Hedge of a Foreign Currency Firm Commitment
12/1/Y1 There is no formal entry for the forward contract or the purchase order.
12/31/Y1 Forward Contract $4,455.45
Gain on Forward Contract $4,455.45
Loss on Firm Commitment $4,455.45
Firm Commitment $4,455.45
10/31/Y1 Loss on Forward Contract $955.45
Forward Contract $955.45
Firm Commitment $955.45
Gain on Firm Commitment $955.45
Foreign Currency (euro) $57,500
Cash $54,000
Forward Contract 3,500
Inventory $57,500
Foreign Currency (euro) $57,500
Firm Commitment $3,500
Adjustment to Net Income $3,500
(Note that this last entry is made in the same period when the inventory affects net income through cost of goods sold.)
CASE 1: Zorba Company (continued)
4. Option Cash Flow Hedge of a Recognized Foreign Currency Liability
The following schedule summarizes the changes in the components of the fair value of the euro call option with a strike price of $1.00 for January 31, Year 2.
Change Change
Spot Option Fair in Fair Intrinsic Time in Time
Date Rate Premium Value Value Value Value Value
12/1/Y1 $1.00 $.04 $2,000 – $0 $2,0001 –
12/31/Y1 $1.10 $.12 $6,000 + $4,000 $5,0002 $1,0002 – $1,000
1/31/Y2 $1.15 $.15 $7,500 + $1,500 $7,500 $03 – $1,000
1 Because the strike price and spot rate are the same, the option has no intrinsic value. Fair value is attributable solely to the time value of the option.
2 With a spot rate of $1.10 and a strike price of $1.00, the option has an intrinsic value of $5,000. The remaining $500 of fair value is attributable to time value.
3 The time value of the option at maturity is zero.
12/1/Y1 Inventory $50,000
Accounts Payable (euro) $50,000
Foreign Currency Option $2,000
Cash $2,000
12/31/Y1 Foreign Exchange Loss $5,000
Accounts Payable (euro) $5,000
Accumulated Other Comprehensive Income (AOCI) $5,000
Gain on Foreign Currency Option $5,000
Foreign Currency Option $4,000
Accumulated Other Comprehensive Income (AOCI) $4,000
Option Expense $1,000
Accumulated Other Comprehensive Income (AOCI) $1,000
1/31/Y2 Foreign Exchange Loss $2,500
Accounts Payable (euro) $2,500
Accumulated Other Comprehensive Income (AOCI) $2,500
Gain on Foreign Currency Option $2,500
Foreign Currency Option $1,500
Accumulated Other Comprehensive Income (AOCI) $1,500
CASE 1: Zorba Company (continued)
4. (continued)
Option Expense $1,000
Accumulated Other Comprehensive Income (AOCI) $1,000
Foreign Currency (euro) $57,500
Cash $50,000
Foreign Currency Option 7,500
Accounts Payable (euro) $57,500
Foreign Currency (euro) $57,500
CASE 1: Zorba Company (continued)
5. Option Fair Value Hedge of a Foreign Currency Firm Commitment
Firm Commitment Option Foreign Currency Option
Spot Change in Premium Change in
Date Rate Fair Value Fair Value for 10/31/Y1 Fair Value Fair Value
9/15/Y1 $1.00 $0 – $.04 $2,000 –
9/30/Y1 $1.10 $(4,950.50) –$4,950.501 $.12 $6,000 +$4,000
10/31/Y1 $1.15 $(7,500) –$2,549.50 $.15 $7,500 +$1,500
1 $50,000 – $55,000 = $(5,000) x .9901 = $(4,950.50), where .9901 is the present value factor for one month at an annual interest rate of 12% (1% per month) calculated as 1/1.01.
12/1/Y1 Foreign Currency Option $2,000
Cash $2,000
9/30/Y1 Foreign Currency Option $4,000
Gain on Foreign Currency Option $4,000
Loss on Firm Commitment $4,950.50
Firm Commitment $4,950.50
10/31/Y1 Foreign Currency Option $1,500
Gain on Foreign Currency Option $1,500
Loss on Firm Commitment $2,549.50
Firm Commitment $2,549.50
Foreign Currency (euro) $57,500
Cash $50,000
Foreign Currency Option 7,500
Inventory $57,500
Foreign Currency (euro) $57,500
Firm Commitment $7,500
Adjustment to Net Income $7,500
(Note that this last entry is made in the same period when the inventory affects net income through cost of goods sold.)
CASE 2: Portofino Company
1. Spreadsheet for the calculation of the foreign exchange gains (losses) related to Portofino Company’s foreign currency accounts payable. Note: These exchange rates were obtained by using the “FXHistory” link found under “Currency Tools” in the left hand column of Oanda’s homepage. These rates are interbank rates. Exchange rates will be different if obtained using the “Currency Converter” link under the “Travelers” column (same as “FX Converter” under “Currency Tools”).
Currency Foreign Currency Account Payable Exchange Rate on 12/15/03 U.S. Dollar Value on 12/15/03 Exchange Rate on 12/31/03 U.S. Dollar Value on 12/31/03 Foreign Exchange Gain (Loss) on 12/31/03
Mexican pesos (MXN) 225,000 0.089008 $20,026.80 0.089111 $20,049.98 $ (23.17)
Brazilian reals (BRL) 60,000 0.3407 $20,442.00 0.3447 $20,682.00 $ (240.00)
Guatemalan quetzals (GTQ) 150,000 0.1279 $19,185.00 0.128 $19,200.00 $ (15.00)
$ (278.17)
Currency Foreign Currency Account Payable Exchange Rate on 12/31/03 U.S. Dollar Value on 12/31/03 Exchange Rate on 1/15/04 U.S. Dollar Value on 1/15/04 Foreign Exchange Gain (Loss) on 1/15/04
Mexican pesos (MXN) 225,000 0.089111 $20,049.98 0.092302 $20,767.95 $ (717.98)
Brazilian reals (BRL) 60,000 0.3447 $20,682.00 0.3549 $21,294.00 $ (612.00)
Guatemalan quetzals (GTQ) 150,000 0.128 $19,200.00 0.1267 $19,005.00 $ 195.00
$(1,134.98)
2. Portofino would have reported a net foreign exchange loss of $(278.17) in 2003 and a net foreign exchange loss of $(1,134.98) in 2004 related to these three foreign currency payables. The transaction denominated in Brazilian reals resulted in the largest overall foreign exchange loss ($852.00) and would have been the most important to hedge.
CASE 2: Portofino Company (continued)
3. Portofino would have benefited from the purchase of call options on the transactions in Mexican pesos and Brazilian reals. The net cash outflow would have been $641.15 less ($741.15 loss avoided less $100.00 cost of option) if a call option had been acquired on the MXN payable, and $752.00 less ($852.00 loss avoided less $100.00 cost of option) if a BRL option had been acquired. Net gains on the options in these amounts would have been recognized. A call option in GTQ would have had no value at 1/15/04.
CASE 3: Better Food Corporation
Memorandum
To: Harvey Carlisle, CEO
The advantage of using forward contracts is that there is no cost to enter them. The disadvantage is that the company is obligated to exchange foreign currency for dollars at the contracted forward rate. Depending upon the future spot rate, this may or may not be advantageous for the company.
The disadvantage of using options is that there is an up-front cost incurred. The advantage is that the company is not required to exchange foreign currency for dollars at the option strike price if it is disadvantageous to do so.
Exporters sometimes use forward contracts to hedge export sales when the foreign currency is selling at a forward premium as this locks in premium revenue. The risk associated with this strategy is that the customer may or may not pay on time. If an exporter enters into forward contract to sell foreign currency, and the customer does not pay on time, the exporter will need to purchase foreign currency at the spot rate to settle the forward contract. This is essentially the same as speculation; a gain or loss could arise. In this case, the exporter might be better off by purchasing a foreign currency put option. The exporter can simply allow the option to expire if it has not received foreign currency from the customer by the expiration date.
Since BFC is making import purchases, it has more control over the timing of when it will need foreign currency to pay for its purchases. In that case, it should be safe to enter into a forward contract to purchase foreign currency on the date when BFC plans to pay. However, there is always the risk that the supplier does not deliver, in which case the forward contract provides BFC with foreign currency for which it has no current use.
The bottom line is that there is no right or wrong answer to the question, which hedging instrument should be used to hedge the Japanese yen exposure to foreign exchange risk, nor to the question whether a hedge should be used at all.