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Chapter 12

Derivatives and Foreign Currency: Concepts and Common Transactions


Answers to Questions
1

Derivative is the name given to a broad range of financial securities. Their common characteristic is that
the derivative contracts value to the investor is directly related to fluctuations in price, rate, or some other
variable that underlies it. Interest rate, foreign currency exchange rate, commodity prices and stock prices
are common types of prices and rate risks that companies hedge.

A Forward is negotiated directly with a counterparty, while a future is a standard contract traded on an
exchange. The exchange traded instrument has less risk of non-performance, and is commonly cheaper to
transact. But standard contracts might not fit all companies needs. The forward carries the risk of
counterparty default, but each contract can be tailored to exact needs.

An option gives the holder the right to buy or sell the underlying at a set price. The writer of an option has
the obligation to either buy or sell. Options are often traded on exchanges and have low transaction costs.
Because an option is an agreement on a single transaction, they are not helpful in managing the risk of a
stream of future transactions. A swap is an agreement to exchange a series of future cash flows. These are
often negotiated, but there are some standardized exchange-traded swaps.

Net settlement means the instrument can be settled in cash for the net value. The parties in a net
settlement do not have to buy or sell physical products and then realize the cash flows. Only one payment
needs to be made, either from the holder or the writer of the instrument.

A transaction is measured in a particular currency if its magnitude is expressed in that currency. Assets
and liabilities are denominated in a currency if their amounts are fixed in terms of that currency.

Direct quotation: 1.20/1 = $1.20


Indirect quotation: 1/1.20 = .83 euros per dollar

Official or fixed rates are set by a government and do not change as a result of changes in world currency
markets. Free or floating exchange rates are those that reflect fluctuating market prices for currency based
on supply and demand factors in world currency markets. The United States changed from fixed to
floating (free) exchange rates in 1971. But the U.S. dollar is sometimes described as a filthy float
because the United States has frequently engaged in currency transactions to support or weaken the dollar
against other currencies. Such action is taken for economic reasons, such as to make U.S. goods more
competitive in world markets. Both Japan and Germany have engaged in currency transactions in an
attempt to support the U.S. dollar. In February 1987, the United States and six other industrial nations
(the Group of 7 or G-7) entered the Louvre accord to cooperate on economic and monetary policies in
support of agreed upon exchange rate levels.

Spot rates are the exchange rates for immediate delivery of currencies exchanged. The current rate for
foreign currency transactions is the spot rate in effect for immediate settlement of the amounts
denominated in foreign currency at the balance sheet date. Historical rates are the rates that were in effect
on the date that a particular event or transaction occurred. Spot rates could be fixed rates if the currency
was a fixed rate currency as determined by the government issuing the currency.

The transaction is a foreign transaction because it involves import activities, but it is not a foreign
currency transaction for the U.S. firm because it is denominated in local currency. It is a foreign currency
transaction for the Japanese company.

10

At the transaction date, assets and liabilities denominated in foreign currency are translated into dollars by
use of the exchange rate in effect at that date, and they are recorded at that amount.

12-2

Derivatives and Foreign Currency: Concepts and Common Transactions

At the balance sheet date, cash and amounts owed by or to the enterprise that are denominated in foreign
currency are adjusted to reflect the current rate. Assets carried at market whose current market price is
stated in a foreign currency are adjusted to the equivalent dollar market price at the balance sheet date.
11

Exchange gains and losses occur because of changes in the exchange rates between the transaction date
and the date of settlement. Both exchange gains and exchange losses can occur in either foreign import
activities or foreign export activities. The statement is erroneous.

12

Exchange gains and losses on foreign currency transactions are reflected in income in the period in which
the exchange rate changes except for hedges of an identifiable foreign currency commitment where
deferral is possible if certain requirements are met. Also hedges of a net investment in a foreign entity are
treated as equity adjustments from translation. Intercompany foreign currency transactions of a long-term
nature are also treated as equity adjustments.

13

There will be a $20 exchange loss in the period of purchase and a $10 exchange gain in the period of
settlement:
Billing date
Purchases
Accounts payable (fc)
Year-end adjustment
Exchange loss
Accounts payable (fc)
Settlement date
Accounts payable (fc)
Cash
Exchange gain

$1,450
$1,450
$

20
$

20

$1,470

Pearson Education, Inc. publishing as Prentice Hall

$1,460
10

Chapter 12

12-3

SOLUTIONS TO EXERCISES
Solution E12-1
1
2
3
4

b
c
d
a

Solution E12-2
1
2
3
4

c
a
d
b

Solution E12-3
1
2
3

b
d
d

Solution E12-4
1

The dollar has weakened against the yen because it now costs more
dollars to buy one yen.

10,000,000 yen $.0075 = $75,000

Accounts payable
Exchange loss
Cash

Zimmer would have


This would assure
their obligation,
needed to satisfy

$75,000
1,000
$76,000
entered a contract to purchase yen for future receipt.
that Zimmer had the yen available at that date to pay
and would have locked in the amount of US dollars
that obligation.

Solution E12-5
December 16, 2011
Inventory

$36,000
Accounts payable (euros)
$36,000
To record purchase of merchandise from Wing Corporation for 30,000
euros at $1.20 spot rate.

December 31, 2011


Exchange loss
$
1,500
Accounts payable (euros)
$
1,500
To adjust accounts payable to Wing: ($1.25 - $1.20) 30,000
euros.
January 15, 2012
Accounts payable (euros)

$37,500

Pearson Education, Inc. publishing as Prentice Hall

12-4

Derivatives and Foreign Currency: Concepts and Common Transactions

Exchange gain
$
300
Cash
37,200
To record payment of 30,000 euros at $1.24 spot rate in settlement
of account payable and to recognize gain.
Solution E12-6
Adjustment in value of account receivable for 2011:
($.84 - $.80) 90,000 C$ = $3,600 exchange gain
Adjustment in value of account receivable at settlement in 2012:
($.83 - $.84) 90,000 C$ = $900 exchange loss
Solution E12-7
May 1, 2011
Accounts receivable (fc)
$333,333
Sales
$333,333
To record sale of inventory items to Royal for 200,000 pounds:
200,000 pounds/.6000 pounds (indirect quotation).
May 30, 2011
Cash (fc)
$330,579
Exchange loss
2,754
Accounts receivable (fc)
$333,333
To record receipt of 200,000 pounds from Royal in settlement of
accounts receivable: 200,000 pounds/.6050 pounds.
Solution E12-8 [Based on AICPA]
1
Receivable at 10/15/08
Euros received and sold for
U.S. dollars on 11/16/08
Foreign exchange loss 2011
2

$420,000
415,000
5,000

On December 31, 2011 Yumi Corp. adjusts its account payable denominated
in euros from $12,000 (10,000*.$1.20) to $12,400 (10,000 $1.24) and
recognizes a loss of $400 [10,000 LCU ($1.24 - $1.20)]

3
December 31, 2011 note payable
July 1, 2012 note payable
2012 exchange loss

$240,000
280,000
$(40,000)

Note receivable December 31, 2011


Amount collected July 1, 2012
(840,000 LCU 8)
2012 exchange loss

$140,000

Pearson Education, Inc. publishing as Prentice Hall

105,000
$ 35,000

Chapter 12

12-5

Solution E12-9
1

Exchange gain or loss in 2011:


Account receivable December 16
December 31 adjusted balance
150,000 C$ $0.68
Account payable December 2
December 31 adjusted balance
275,000 C$ $0.68
Net exchange gain for 2011
Exchange gain or loss in 2012:
Account receivable adjusted 12/31
Account receivable 1/15/09
150,000 C$ x $0.675
Account payable adjusted 12/31
Account payable 1/30/09
275,000 C$ x $0.685
Net exchange loss for 2012

Gain or (Loss)
$103,500
102,000
$195,250

$(1,500)

187,000

8,250
$ 6,750
Gain or (Loss)

$102,000
101,250
$187,000

188,375

(750)

(1,375)
$(2,125)

Solution E12-10
1

December 12, 2011


Inventory
Accounts payable (yen)

$375,000
$375,000

$.00750).

Purchase from Toko Company (50,000,000 yen


December 15, 2011
Accounts receivable (pounds)
Sales

$ 66,000
$ 66,000

Sale to British Products Company (40,000 pounds

$1.65).

December 31, 2011


Exchange loss
$ 5,000
Accounts payable (yen)
$ 5,000
To adjust accounts payable denominated in yen for exchange rate
change: 50,000,000 yen ($.00760 - $.00750).
Exchange loss
$ 2,000
Accounts receivable (pounds)
$ 2,000
To adjust accounts receivable denominated in pounds for exchange
rate change: 40,000 pounds ($1.65 - $1.60).

January 11, 2012


Accounts payable (yen)
Exchange loss
Cash

$380,000
2,500
$382,500

$.00765).

To record payment to Toko Company (50,000,000 yen


January 14, 2012
Cash
Accounts receivable (pounds)

$ 65,200

Pearson Education, Inc. publishing as Prentice Hall

$ 64,000

12-6

Derivatives and Foreign Currency: Concepts and Common Transactions

Exchange gain
1,200
To record receipt from British Products Company: 40,000 pounds
$1.63.

Pearson Education, Inc. publishing as Prentice Hall

Chapter 12

12-7

Solution E12-11
Comment: The contract receivable and payable are both recorded instead of
recording the contract net because Martin must deliver the euros to the
exchange broker, net settlement is not allowed.
October 2, 2011
Contract receivable
$653,000
Contract payable (fc)
$653,000
To record contract to sell 1,000,000 euros to exchange broker in
180 days for the forward rate of $.6530.
December 31, 2011
Contract payable (fc)
$ 12,000
Exchange gain
$ 12,000
To adjust contract payable in euros to the 90-day forward rate of
$.6410.
March 31, 2012
Contract payable (fc)
$641,000
Exchange loss
14,000
Cash (fc)
$655,000
To record payment of 1,000,000 euros to exchange broker when spot
rate is $.6550.
Cash

$653,000
Contract receivable
$653,000
To record receipt of U.S. dollars from exchange broker in
settlement of account.

SOLUTIONS TO PROBLEMS
Solution P12-1
TCO would receive $8,000 from XYZ = 100,000(2.48-2.40)
Solution P12-2
There is a typo in the problem, Sue's cost should be $5.90
The expected profit for Sue is 300,000 (6.20 - 5.90) = 90,000

Market Price
per Bushel

Forward Price
per Bushel

Unhedged
Gain/(Loss)

$6.40

$6.20

$150,000

$6.30

$6.20

120,000

$6.20

$6.20

$6.10

$6.20

$6.00

$6.20

Economic Gain/
(Loss) on
Forward

Economic
Income with
Hedge

$(60,000)

$90,000

(30,000)

90,000

90,000

60,000

30,000

90,000

30,000

60,000

90,000

90,000

Pearson Education, Inc. publishing as Prentice Hall

12-8

Derivatives and Foreign Currency: Concepts and Common Transactions

Solution P12-3
The expected profit for Sue is 300,000(6.20 - 5.90 - 0.05) = 75,000

Unhedged
Gain/(Loss)

Economic Gain/
(Loss) on
Option

Economic
Income (Loss)
with Cost of
Option

Market Price
per Bushel

Option Price
per Bushel

$6.40

$6.20

$150,000

---

$135,000

$6.30

$6.20

120,000

---

105,000

$6.20

$6.20

75,000

$6.10

$6.20

60,000

30,000

75,000

$6.00

$6.20

30,000

60,000

75,000

90,000

Solution P12-4
1, 2
Accounts receivable
U.S. dollars
Swedish Krona (20,000 $.66)
British pounds(25,000 $1.65)
Accounts payable
U.S. dollars
Canadian dollars (10,000 $.70)
British pounds (15,000 $1.65)

Per
Books

Balance
Sheet

Exchange Gain
or (Loss)

$28,500
11,800
41,000
$81,300

$28,500
13,200
41,250
$82,950

$1,400
250
1,650

$ 6,850
7,600
24,450
$38,900

$ 6,850
7,000
24,750
$38,600

Net exchange gain


3

600
(300)
300
$1,950

Collect receivables:
Cash

$28,500
Accounts receivable
To record collection of accounts receivable.

Cash

$28,500

$13,400
Accounts receivable (Krona)
Exchange gain
To collect 20,000 Krona at $.67 spot rate.

Cash
$40,750
Exchange loss
500
Accounts receivable (pounds)
To collect 25,000 pounds at $1.63 spot rate.

Pearson Education, Inc. publishing as Prentice Hall

$13,200
200

$41,250

Chapter 12

12-9

Settlement of accounts payable:


Accounts payable
$ 6,850
Cash
$ 6,850
To record payment of accounts denominated in dollars.
Accounts payable (Canadian $)
$ 7,000
Exchange loss
100
Cash
$ 7,100
To record payment of account denominated in Canadian dollars at
$.71 spot rate.
Accounts payable (pounds)
$24,750
Cash
$24,300
Exchange gain
450
To record payment of 15,000 pounds at $1.62 spot rate.

Solution P12-5
1, 2
Accounts receivable
British pounds (100,000 1.660)
Euros (250,000 $.670)
Swedish krona (160,000 $.640)
Japanese yen (2,000,000 $.0076)
Accounts payable
Canadian dollars(150,000 $.69)
Swedish krona (220,000 $.135)
Japanese yen (4,500,000 $.0076)

Per Books

Balance
Sheet

Exchange Gain
or (Loss)

$165,000
165,000
105,600
15,000
$450,600

$166,000
167,500
102,400
15,200
$451,100

$1,000
2,500
(3,200)
200
500

$105,000
28,600
33,300
$166,900

$103,500
29,700
34,200
$167,400

$1,500
(1,100)
(900)
(500)

Net exchange gain


3

The company would need to enter into a contract to deliver 250,000 euros
(sell them) since it would be receiving euros and would need to convert
them into US dollars.

Pearson Education, Inc. publishing as Prentice Hall

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