Slide 9 1 Chapter Nine Foreign Currency Transactions

Slide 9 -1 Chapter Nine Foreign Currency Transactions and Hedging Foreign Exchange Risk Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2004

Slide 9 -2 Foreign Exchange Markets Each country uses its own currency for internal economic transactions. l To make transactions in another country, units of that country’s currency must be acquired. l The cost of those currencies is called the exchange rate. l Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2004

Slide 9 -3 Exchange Rate Mechanisms Prior to 1973, currency values were generally fixed. The US $ was based on the Gold Standard. l Since 1973, exchange rates have been allowed to fluctuate. l Several valuation models exist. l Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2004

Slide 9 -4 Foreign Exchange Rates l Exchange rates are published daily in the Wall Street Journal. v These are “end-of-day” rates. v As of 4: 00 pm Eastern time l Remember – Rates change constantly during the day Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2004

Slide 9 -5 Foreign Exchange Rates As the relative strength of a country’s economy changes. . . the exchange rate of the local currency relative to other currencies also fluctuates. Mc. Graw-Hill/Irwin Spot Rates l The exchange rate that is available today. Forward Rates l The exchange rate that can be locked in today for an expected future exchange transaction. l The actual spot rate at the future date may differ from today’s forward rate. © The Mc. Graw-Hill Companies, Inc. , 2004

Slide 9 -6 Foreign Exchange Forward Contracts A forward contract requires the purchase of currency units at a future date at the contracted exchange rate. This forward contract allows us to purchase 1, 000 ¥ at a price of $. 0080 US in 30 days. Mc. Graw-Hill/Irwin But if the spot rate is $. 0069 US in 30 days, we still have to pay $. 0080 US and we lose $1, 100! © The Mc. Graw-Hill Companies, Inc. , 2004

Slide 9 -7 Foreign Exchange Options Contracts An options contract gives the holder the option of buying the currency units at a future date at the contracted “strike” price. An alternative is an option contract to purchase 1, 000 ¥ at $. 0080 US in 30 days. But it costs $. 00002 per ¥. Mc. Graw-Hill/Irwin That way, if the spot rate is $. 0069 in 30 days, we only lose the $20 cost of the option contract! © The Mc. Graw-Hill Companies, Inc. , 2004

Slide 9 -8 Foreign Currency Transactions A U. S. company buys or sells goods or services to a party in another country. l The transaction is often denominated in the currency of the foreign party. l Mc. Graw-Hill/Irwin The major accounting issue: How do we account for the changes in the value of the foreign currency? © The Mc. Graw-Hill Companies, Inc. , 2004

Slide 9 -9 Foreign Currency Transactions FASB No. 52 Requires a two-transaction perspective. (1) Account for the original sale in US $ (2) Account for gains/losses from exchange rate fluctuations. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2004

Slide 9 -10 Foreign Currency Transactions When a transaction occurs on one date (for example a credit sale). . . but the cash flow is at a later date. . . ? . . . fluctuating exchange rates can result in exchange rate gains or losses. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2004

Slide 9 -11 Foreign Currency Transactions When the rate is expressed as the US $ equivalent of 1 unit of foreign currency, the rate is called a “DIRECT QUOTE” Mc. Graw-Hill/Irwin ? © The Mc. Graw-Hill Companies, Inc. , 2004

Slide 9 -12 Foreign Currency Transactions When the rate is expressed as the US $ equivalent of 1 unit of foreign currency, the rate is called a “DIRECT QUOTE” When the rate is expressed as the number of foreign currency units that $1 will buy, the rate is called an “INDIRECT QUOTE” Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2004

Slide 9 -13 Foreign Exchange Transaction Example On 12/1/04, Bob. Co sells inventory to Coventry Corp. on credit. Coventry will pay Bob. Co 10, 000 British pounds in 90 days. The current exchange rate is $1 =. 6425 £. Prepare Bob. Co’s journal entry. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2004

Slide 9 -14 Foreign Exchange Transaction Example On 12/31/04, the exchange rate is $1 =. 6400 £. At the balance sheet date we have to “remeasure”, or adjust, the original A/R to the current exchange rate. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2004

Slide 9 -15 Foreign Exchange Transaction Example On 3/1/05, Coventry Corp. pays Bob. Co the 10, 000 £ for the 12/1/04 sale. The exchange rate on 3/1/05, was $1 =. 6500 £. On 3/1/05, we have to do TWO things. First, we have to “remeasure” the A/R. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2004

Slide 9 -16 Foreign Exchange Transaction Example On 3/1/05, Coventry Corp. pays Bob. Co the 10, 000 £ for the 12/1/04 sale. The exchange rate on 3/1/05, was $1 =. 6500 £. On 3/1/05, we have to do TWO things. Second, we have record the receipt of the £. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2004

Slide 9 -17 Hedging Foreign Exchange Risk To control for the risk of exchange rate fluctuation, a forward contract for currency can be purchased. Mc. Graw-Hill/Irwin Hedging effectively reduces the uncertainty associated with fluctuating exchange rates. © The Mc. Graw-Hill Companies, Inc. , 2004

Slide 9 -18 Hedging Foreign Exchange Risk To hedge a foreign currency transaction, companies use foreign currency derivatives l Two most common tools: l v Foreign currency forward contracts v Foreign currency options Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2004