CHAPTER 7
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. Foreign
exchange gains and losses on foreign currency balances are 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. Derivative financial instruments are 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. IAS 39 (and FASB ASC 830) 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).