FOREIGN CURRENCY TRANSACTIONS AND

HEDGING FOREIGN EXCHANGE RISK

Chapter 6

McGraw-Hill/Irwin

Copyright 2009 by The McGraw-Hill Companies, Inc. All

Foreign Currency Transactions and

Hedging Foreign Exchange Risk
Chapter Topics

Foreign exchange markets

Foreign exchange risk
Accounting for foreign currency transactions
Hedging
Foreign currency forward contracts and options
Accounting for hedges
Cash flow hedges and fair value hedges

6-2

Foreign Currency Transactions and

Hedging Foreign Exchange Risk
Learning Objectives
1. Provide an overview of the foreign exchange market.
2. Explain how fluctuations in exchange rates give rise to foreign
exchange risk.
3. Demonstrate the accounting for foreign currency transactions.
4. Describe how foreign currency forward contracts and foreign
currency options can be used to hedge foreign exchange risk.

6-3

Foreign Currency Transactions and

Hedging Foreign Exchange Risk
Learning Objectives
5. Describe the concepts of cash flow hedges, fair value hedges, and
hedge accounting.
6. 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.

6-4

Foreign Exchange Markets

Foreign exchange rate

Purchase price of a foreign currency-- e.g., in December 2007 it
cost about 0.09 U.S. dollars (nine cents) to purchase one Mexican
peso.
From 1945 to 1973 countries had exchange rates fixed to the U.S.
dollar.
U.S. dollar was fixed to gold at $35 per ounce.
Balance-of-payments deficits in the U.S. during the 1960s doomed
this system, so, by March 1973 most currencies were allowed to
float in value.

Learning Objective 1

6-5

Foreign Exchange Markets

Exchange Rate Mechanisms

Independent float currency value allowed to move freely with
little government intervention.
Pegged to another currency currency value fixed (pegged) in
terms of a particular foreign currency (e.g., U.S. dollar), and
central bank intervenes to maintain the exchange rate.
European Monetary System (Euro) twelve countries use a
single currency, which floats against other currencies such as the
U.S. dollar.

Learning Objective 1

6-6

Foreign Exchange Markets

Foreign Exchange Rates
Exchange rates, to the U.S. dollar, are published in many places on the
internet and in newspapers.
Exchange rates are reflected both as US$ equivalent (direct quotes)
and currency per US$ (indirect quotes).
For example, on February 15, 2008 the direct quote for a Euro was
$1.4595 and the indirect quote was $0.6852. As a point of comparison,
the direct quote when the Euro first appeared in 1998 was
approximately $1.17 and the indirect quote was approximately $0.85.
A direct quote is the reciprocal of an indirect quote and vice-versa.

Learning Objective 1

6-7

Foreign Exchange Markets

Spot rates and Forward rates

Spot rate todays price for purchasing or selling a foreign
currency.
Forward rate todays 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.

Learning Objective 1

6-8

Foreign Exchange Markets

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.

Learning Objective 1

6-9

Foreign Exchange Markets

Option contracts
Option premium cost of purchasing the option, which is a
function of the options 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.

Learning Objective 1

6-10

Exchange Rates and Foreign

Exchange Risk
Terminology
Export sale a company sells to a foreign customer and later
receives payment in the customers currency.
Import purchase a company purchases from a foreign supplier
and later pays in the suppliers currency.
Foreign exchange risk the chance that the exporter will receive
less or that the importer will pay more than anticipated as a result
of a change in the exchange rate.

Learning Objective 2

6-11

Exchange Rates and Foreign

Exchange Risk
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).

Learning Objective 2

6-12

Exchange Rates and Foreign

Exchange Risk
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.

Learning Objective 2

6-13

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, and sale is measured at converted amount.
This approach is not allowed under IAS or U.S. GAAP.

Learning Objective 3

6-14

Accounting for Foreign

Currency Transactions
Two transaction perspective

Treats sale and collection as two transactions

Sale is one transaction and collection is a 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.

Learning Objective 3

6-15

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.

Learning Objective 3

6-16

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.

Learning Objective 3

6-17

Accounting for Foreign

Currency Transactions
Export sale example 1
February 1, 2008, 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, 2008.
Assume spot rate as of February 1, 2008 is $0.10 per peso.

Learning Objective 3

6-18

Accounting for Foreign

Currency Transactions
Export sale example 1
Joe, Inc. records the sale (in U.S. $) on February 1, 2008 as follows:
Accounts Receivable
Sales

Learning Objective 3

100,000
100,000

6-19

Accounting for Foreign

Currency Transactions
Export sale example 1
On March 2, 2008, 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
Foreign Exchange Loss
Accounts Receivable

Learning Objective 3

90,000
10,000
100,000

6-20

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, 2007
rather than February 1, 2008.
Spot rate as of December 1, 2007 is $0.11 per peso.
Spot rate as of December 31, 2007 is $0.105 per peso.
Joe Inc. has a December 31 year end.

Learning Objective 3

6-21

Accounting for Foreign

Currency Transactions
Export sale example 2
Joe, Inc. records the sale (in U.S. $) on December 1, 2007 and the
foreign exchange loss on December 31, 2008 as follows:
Accounts Receivable
Sales
Foreign Exchange Loss
Accounts Receivable

Learning Objective 3

110,000
110,000
5,000
5,000

6-22

Accounting for Foreign

Currency
Transactions
Export sale example 2
Joe, Inc. records the receivable collection and an additional foreign
exchange loss on March 2, 2008:
Cash
Foreign Exchange Loss
Accounts Receivable

Learning Objective 3

90,000
15,000
105,000

6-23

Hedging Foreign Exchange Risk

Hedging -- protecting against losses from exchange rate

fluctuations. Companies often use foreign currency forward
contracts and foreign currency options.
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.

Learning Objective 4

6-24

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, 2007.

Learning Objective 4

6-25

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, 2008.
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.

Learning Objective 4

6-26

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, 2007.
The option premium is $4,000.

Learning Objective 4

6-27

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, 2008.
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.

Learning Objective 4

6-28

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.
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.

Learning Objective 5

6-29

Hedge Accounting

Hedge accounting examples

1.
2.
3.
4.
5.
6.

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

Learning Objective 6

6-30

Hedge Accounting
Assumptions for examples 1 and 2
December 1, 2007, 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, 2008.
Spot rates per peso are: December 1, 2007, $0.11, December 31,
2007, $0.10, and March 2, 2008, $0.095.
The annual interest rate is 6% (0.5% per month).

Learning Objective 6

6-31

Hedge Accounting

Joe enters a foreign currency forward contract on December 1,

2007.
The contract calls for Joe to sell 1,000,000 pesos at a forward rate
of $0.105, on March 2, 2008.
The forward rate on December 31, 2007 for March 2, 2008
delivery is $0.096.

Learning Objective 6

6-32

Hedge Accounting
Example 1, FC asset/forward/cash flow hedge
12/01/07
Accounts receivable
Sales

110,000

12/31/07
Foreign exchange loss
Accounts receivable

10,000

Accumulated Other Comprehensive Income

Gain on forward contract

10,000

Learning Objective 6

110,000

10,000
10,000

6-33

Hedge Accounting

Example 1, FC asset/forward/cash flow hedge

12/31/07
Forward contract
Accumulated Other Comprehensive Income

8,911

Discount expense*
Accumulated Other Comprehensive Income

1,667

8,911
1,667

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

Learning Objective 6

6-34

Hedge Accounting

Example 1, FC asset/forward/cash flow hedge

3/02/08
Foreign exchange loss
Accounts receivable

5,000

Accumulated Other Comprehensive Income

Gain on forward contract

5,000

Forward contract
Accumulated Other Comprehensive Income

1,089

Learning Objective 6

5,000
5,000
1,089

6-35

Hedge Accounting

Example 1, FC asset/forward/cash flow hedge

3/02/08
Discount expense
3,333
Accumulated Other Comprehensive Income
3,333
Foreign currency
Accounts receivable
Cash
Foreign currency
Forward contract

Learning Objective 6

95,000
105,000

95,000
95,000

10,000

6-36

Hedge Accounting
Example 2, FC asset/forward/fair value hedge
12/01/07
Accounts receivable
Sales
110,000

110,000

12/31/07
Foreign exchange loss
Accounts receivable
Forward contract
8,911
Gain on forward contract

Learning Objective 6

10,000
10,000
8,911

6-37

Hedge Accounting

Example 2, FC asset/forward/fair value hedge

3/02/08
Foreign exchange loss
Accounts receivable
Forward contract
Gain on forward contract

Learning Objective 6

5,000
1,089

5,000
1,089

6-38

Hedge Accounting

Example 2, FC asset/forward/fair value hedge

3/02/08
Foreign currency
Accounts receivable
Cash

Foreign currency
Forward contract

Learning Objective 6

95,000
105,000

95,000
95,000
10,000

6-39