Chapter 13
Managing Foreign Exchange
Exposure
Outright Forward Market

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
Forward contract is a contract between a
foreign currency trader and a client for future
sale or purchase of foreign currency
Forward contract is a derivative because its
future value is based on the current spot
exchange rate
During a period of stability, little difference
may exist between the current spot and
forward rates
International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black
Outright Forward Market
Example from The Wall Street Journal
90-day forward
Spot
Points
British Pounds
$1.8983
$1.9077
-94
Spread is -.0094 or 94 points (discount)
International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black
Outright Forward Market
Premium (discount) = Fo – So x 12 x 100
So N
If forward rate < spot rate, DISCOUNT
If forward rate > spot rate, PREMIUM
Fo = forward rate on the day that the contract is
entered into
So = spot rate on that day
N = number of months forward
100 is used to convert the decimal to a %
International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black
Outright Forward Market
Example from The Wall Street Journal
Premium = 1.8983 – 1.9077 x 12 x 100
= -1.97%
Pound is selling at a 1.97% discount below the
dollar spot rate
International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black
Swaps
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A swap is a simultaneous spot and forward
transaction
Variation of this is a foreign exchange swap
based on interest rate differentials
The swap exchange rate is the rate at which
two companies agree to exchange one
currency for the other
International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black
Futures
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Specifies an exchange rate sometime in advance of
the actual exchange of currency
Traded on an exchange, not OTC
Futures contract is for a specific amount and a
specific maturity date
Less valuable to a company than a forward contract
May be useful to speculators and small companies
Contract months are March, June, Sept., Dec.
Less flexible than forward contracts
International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black
Options
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The right but not the obligation to trade foreign
currency at a given exchange rate on or before a
given date in the future
Can be traded on an exchange or with a financial
intermediary
Two parties to an option
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Writer – sells the option
Holder – buys the option, pays a premium to the writer
Holder determines whether or not the option will be
exercised
International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black
Foreign Exchange Markets

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Central Bank survey by the Bank of International Settlement in
Basel, Switzerland
 Global net turnover of foreign exchange is estimated to be $1.9
trillion per business day
Interbank market is the most important market in trading foreign
exchange
Banks also deal indirectly with each other through foreign
exchange brokers
Movement toward computer-based trades
Foreign exchange is traded on
 Specialized market – International Monetary Fund of the Chicago
Mercantile Exchange
 OTC revolves around investment banks like Goldman Sachs
International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black
Foreign Exchange Markets

Most widely traded instrument is swaps,
followed by spot transactions and outright
forwards
International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black
The International Monetary
System


International Monetary Fund (IMF) created in 1944
to promote exchange stability
Exchange Rate Arrangements
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IMF permits countries to select and maintain an
arrangement of their choosing as long as they
communicate the arrangement to the fund
Some countries lock their currencies onto another currency
– Ecuador and the U.S. dollar
Other countries adopt a free float or a managed float
Importance lies in the relation of the home office currency
to the currencies in countries where the company has
operations
 Example – U.S. dollar was stable against the Chinese yuan,
but weak against the euro, pound, and yen in 2004
International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black
The Determination of
Exchange Rates
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
Fisher Effect – the nominal interest rate
equals the real rate of interest worldwide plus
the expected inflation rate
International Fisher Effect


The country with the higher nominal interest rate
should have a higher rate of inflation
The country with the higher nominal interest rate
should expect its currency to weaken against a
low-interest-rate (low-inflation) country
International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black
The Determination of
Exchange Rates

Important factors affecting exchange rates

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Purchasing power parity (PPP) or inflation differentials
Relative interest rates
The forward exchange rate
According to PPP, a change in relative inflation must
result in a change in exchange rates to keep the
prices of goods in two countries similar, taking into
consideration transportation costs.
PPP is a good long-run indicator of exchange rate
differences
International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black
The Determination of
Exchange Rates
Higher inflation
=
weakening currency
Lower inflation
=
stronger currency
International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black
The Determination of
Exchange Rates


The forward rate differs from the spot rate by
a percentage equal to the projected
exchange rate
Political issues can change exchange rate
differentials

Example – 2002 Presidential election in Brazil
 Brazilian real fell against the U.S. dollar because
of a perceived leftist president
 When the president turned out to be conservative,
the real strengthened against the dollar
International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black
Unbiased Forward Rate Theory
International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black
Transaction Exposure

When a company engages in foreign currency
transactions, a foreign exchange risk is incurred
Example


If a U.S. exporter receives payment in U.S. dollars from a
British importer, there is no immediate impact on the
exporter if the exchange rate changes
The British importer has a cash flow gain/loss from the
change in exchange rates because their accounts payable
would change in value as the exchange rate changes
International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black
Translation or Accounting
Exposure
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Accounting exposure arises when a company translates
its financial statements from one currency to another for
consolidation purposes
If current rate method is used, all accounts except
owners’ equity change in value with the exchange rate
If the temporal method is used, only the monetary
accounts are translated into dollars at the current rate
method and exposed to exchange gains and losses
International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black
Translation or Accounting
Exposure
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Current rate method is likely to have an exposed
asset position
Temporal method is likely to have an exposed
liability position
Firms are positively exposed with income earned in
a strong currency country
Income earned in a weak currency country will be
reduced by the weak exchange rate
Dividend flows follow the same pattern as income
Results under the temporal method will be mixed
International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black
Economic (Operating)
Exposure


Economic exposure is the potential for
change in expected cash flows
Economic exposure arises from



Pricing of products
Sourcing and cost of inputs
Location of investments
International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black
Economic (Operating)
Exposure

Example by Aeppel, 2005

Superior Products Inc., a U.S. company, found
that prices for valves it was sourcing from
Germany were continuing to rise. As a result,
Superior’s management decided to begin
producing the valves itself and selling them to
U.S. customers. When the Germans realized
what was happening, they lowered their prices,
but it was too late.
International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black
Economic (Operating)
Exposure
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Future events have more economic exposure
than transactions exposure because of the
different ways to account for and hedge them
Currency of a country could affect its
competitiveness as a production location
Example (Aeppel, 2005)

Bison Gear and Engineering Corp. closed down
its facility in Holland when the dollar was weak,
manufactured its products in the U.S., and sold
them back into Europe.
International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black
Hedging Strategies

Duffey’s Six Reasons Why Management Does Nothing (2003)
 Managers do not take time to understand the issue
 Managers claim that exposure cannot be measured
 Managers say that the firm is hedged through hedging of
transactions, without understanding the broader economic
exposure
 Managers say that the firm does not have any exchange risk
because it does all of its transactions in the reporting currency.
Management ignores economic risk
 Management argues that doing business is risky and the firm
gets rewarded for bearing both business and financial risks
 The balance sheet is hedged on an accounting basis, especially
when the functional currency is the reporting currency
International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black
Financial Strategies
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Hedge exposure by use of derivatives
Enter into foreign currency debt
Use derivatives to hedge income statement
or balance sheet exposure
If a company is in a net monetary asset
position, it will enter a contract to sell foreign
currency.
If a company is in a net liability position, it will
enter a contract to buy foreign currency
International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black
Operating Strategies

Operating hedges are usually



More complicated and costly than financial hedges
Involved in betting on the exposure of the entire firm rather
than just specific financial transactions
Companies can balance costs with revenues

Examples
 A company that sells to a European customer might
consider manufacturing in Europe so expenses are in euros
and can offset euro revenues.
 A company might also incur costs in euros so that it can
use euro revenues to pay its euro costs.
International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black
Foreign Exchange Risk
Management Strategies

Four steps to protect against exchange rate
exposure
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Define and measure exposure
Organize and implement a reporting system that
monitors exposure and exchange-rate
movements
Adopt a policy assigning responsibility for
minimizing – or hedging – exposure
Formulate strategies for hedging exposure
International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black
Define and Measure Exposure


Differentiate between transactions,
translation, and economic exposure
Each type of exposure may require a different
hedging response
International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black
Organize and Implement a
Reporting System
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System must monitor exposure and
exchange-rate movements
System must forecast exposure to establish a
good hedging strategy
Management should set up a uniform
reporting system for all subs that identifies



Exposed accounts that the company wants to
monitor
Amount of exposure by currency of each account
Different time periods in consideration
International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black
Adopt a Policy Assigning
Responsibility
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Determine who is ultimately responsible for
protecting the company from exchange rate
movements
Multidomestic companies usually delegate hedging
strategies to national organizations
Global companies are more likely to centralize
hedging strategies
Corporate should determine overall policy
Corporate should provide forecasts on exchange
rate movements to help local management
International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black
Formulate Hedging Strategies

Choice of exposures to be hedged depends



On risk aversion of the company
On management’s confidence in predicting
exposures
Dell Example


Dell hedges everything
Dell’s Brazilian operations hedge about 80% of
forecasted revenues
International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black
Adopt a Policy Assigning
Responsibility

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
Local management must develop good capabilities
in foreign exchange risk management
Local banking relationships can help local
management develop forecasts of exchange rate
movements
Local management must establish strategies that fit
within corporate guidelines
The more centralized the strategy, the more
corporate will take responsibility for hedging
strategies
Local management will then be free to focus on
operations
International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black
Hedging Standards


IAS 39 and SFAS 133 are very similar
A derivative is defined by three characteristics



Has one or more underlyings (foreign exchange) and one
or more notional amounts (units of foreign currency traded)
or payment provisions or both
Requires no initial net investment or one that is smaller that
would be required for other contracts that would have a
similar response to changes in market factors
Terms require or permit net settlement, it can be readily net
by a means outside the contract, or provides for delivery of
an asset that puts the recipient in a position close to net
settlement
International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black
Hedging Standards

IAS 39 and SFAS 133 require

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
Three kinds of hedges
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All derivatives be recognized as assets or liabilities on the
balance sheet at fair value
Changes in FV are recorded in comprehensive income
Fair-value hedge
Cash flow hedge
Foreign-currency hedge
Hedge accounting matches the recognition of the
gain or loss of the derivative with the gain or loss on
the underlying transaction
International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black
The Use of a Forward Contract
to Hedge a Transaction
International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black
Illustration: A Forward Contract to Hedge a
Foreign Currency Transaction
Redex Imports, a U.S. company, bought
inventory from a British supplier on May 1,
incurring a liability of £50,000 that must be paid
on June 30.
$1.8500
spot rate on May 1
$1.8700
forward rate quoted on May 1 for
delivery on July 30
$1.8800
spot rate on June 30
$1.8900
forward rate quoted on June 30 for
delivery on July 30
$1.9000
spot rate on July 30
International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black
Illustration: A Forward Contract to Hedge a
Foreign Currency Transaction
May 1
Purchases
92,500
A/P
92,500
to record the purchase at the spot
rate of $1.8500
A memorandum entry is made to record
Redex’s commitment to deliver dollars to the
bank and receive £50,000 at the rate of $1.87
International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black
Illustration: A Forward Contract to Hedge a
Foreign Currency Transaction
June 30
Foreign Exchange Loss 1,500
A/P
1,500
£50,000 x (1.88-1.85)
Forward contract
1,000
Foreign exchange gain 1,000
£50,000 x (1.89-1.87)
International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black
Illustration: A Forward Contract to Hedge a
Foreign Currency Transaction
July 30
A/P
Loss
94,000
1,000
Cash
Forward Contract
Gain
£50,000 x (1.90-1.89)
Cash
95,000
500
500
1,500
Forward contract
1,500
Assuming a 6% discount rate, PV for one month (June 30 – July 30) is
$1.8900-1.8700 = .02 x 50,000 = $1,000/(1 + .06/12) = $995
International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black
The Use of a Forward Contract
to Hedge a Commitment
International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black
Illustration: A Forward Contract to
Hedge a Firm Commitment
Redex Imports enters into a commitment to
purchase capital equipment for £1,000,000
from a British manufacturer with delivery to take
place on April 30 and payment to be made on
May 31.
Spot rates
Forward rates
$1.4900
March 1
$1.5700
March 1
$1.5200
March 31
$1.5850
March 31
$1.5500
April 30
$1.5900
April 30
$1.5950
May 31
International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black
Illustration: A Forward Contract to
Hedge a Firm Commitment
PV of forward contract for March 31 – May 31
1.5850 – 1.5700 = .015 x 1,000,000
= $15,000/(1 + .06/6) = $14,851
March 31
Forward Contract
14,851
Gain on forward contract
14,851
Loss on firm commitment
Firm commitment
14,851
14,851
International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black
Illustration: A Forward Contract to
Hedge a Firm Commitment
PV of the contract for March 31 – April 30
$1.59-1.57 = .02 x 1,000,000
= $20,000/(1+.06/12) = $19,900
April 30
Forward contract
Gain on forward contract
5,049
Loss on firm commitment
Firm commitment
5,049
Equipment
Purchase commitment
A/P
5,049
5,049
1,530,100
19,900
1,550,000
International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black
Illustration: A Forward Contract to
Hedge a Firm Commitment
Value of the forward contract on May 31
$1.5950 - $1.5700 = .025 x 1,000,000
= $25,000
May 31
Forward contract
Gain on forward contract
Foreign exchange loss
A/P
A/P
Forward contract
Cash
5,100
5,100
45,000
45,000
1,595,000
25,000
1,570,000
International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black
Illustration: A Forward Contract to Hedge a
Foreign-Currency Forecasted Sale
On March 1, XYZ company estimates it will sell
£1,000,000 of inventory to British customers
effective April 30. XYZ enters into a forward
contract to hedge the British pounds receivable
Spot Rate
March 1
$1.4772
March 31
$1.4950
Date of sale
$1.5100
Forward Rate for April 30
$1.4900
$1.5050
$1.5100
International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black
Illustration: A Forward Contract to Hedge a
Foreign-Currency Forecasted Sale
Nominal Value
FV
Mar 1
0
0
Mar 31
($15,000) ($14,925)
Apr 30
($20,000) ($20,000)
Gain/Loss
0
($14,925)
($5,075)
Fair Value adjustment on March 31
15,000/[1 + (.06/12)] = 14,925
International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black
Illustration: A Forward Contract to Hedge a
Foreign-Currency Forecasted Sale
March 1
No entry
March 31
Other comprehensive income 14,925
Forward contract
14,925
April 30
Other comprehensive income 5,075
Forward contract
5,075
Foreign currency
Sales
1,510,000
1,510,000
International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black
Illustration: A Forward Contract to Hedge a
Foreign-Currency Forecasted Sale
April 30
Forward contract 20,000
Cash
1,490,000
Foreign currency
1,510,000
Sales
20,000
Other comp. income
20,000
International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black
Illustration: An Option Contract to Hedge
Foreign-Currency Forecasted Sale
XYZ enters into a put option for £1,000,000 on
March 1 at a strike price of $1.4900 and a
premium of $20,000. The sale is expected to
take place on June 30, the same time the
option contract expires.
March 1
Foreign-currency options 20,000
Cash
20,000
The option will be adjusted to FV and the adjustment will go to
comprehensive income. When the sale is recorded, this
adjustment will be taken from other comp. income and used to
adjust the amount of sales. Sales revenue and cash received
will be at least $1,490,000.
International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black
Use of Derivatives to Hedge a
Net Investment



SFAS 133 allows hedge accounting for the
hedge of a net investment
Gains and losses are taken to a separate
component of stockholders’ equity
The gain or loss may be included in the
cumulative translation adjustment to the
extent the changes represent an effective
hedge of the net investment
International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black
Disclosure of Derivative
Financial Instruments

Derivatives are subject to the following




Market risk – the risk of loss due to unexpected
changes in interest and exchange rates
Credit risk – the potential loss from counterparty
nonperformance
Liquidity risk – related to market liquidity of
instruments held; closely related to market risk
Operating risk – linked to inadequate controls that
ensure following a properly defined corporate
policy
International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black
Disclosure of Derivative
Financial Instruments



Must disclose the extent of the risk to users
Must provide qualitative and quantitative information
about derivatives
Must disclose




Objectives for holding derivatives
Context needed to understand objectives
Strategies for achieving the objectives
Separate information should be provided for



Fair-value hedges
Cash-flow hedges
Foreign currency hedges
International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black