CH 9.

Foreign Currency Transactions and

Hedging Foreign Exchange Risk
Recap: Handout 2-1
10/1/X1 12/31/X1 4/1/X2

Transaction
date
Balance sheet
date
Settlement
date J/E?
Incur 5,000 yen liability. Inventory?
Pay 5,000 yen to settle liability.

1. Mint Corporation has several transactions with foreign entities. Each transaction is denominated in the local
currency unit of the country in which the foreign entity is located. On October 1, 20X1, Mint purchased
confectionary items from a foreign company at a price of Yen 5,000 when the direct exchange rate was 1 Yen =
$1.20. The account was settled as of April 1, 20X2. Assume that the exchange rate as of 12/31/20x1 were 1 Yen
= $1.10 and as of 4/1/20x2 1 Yen = $ 1.30. The foreign exchange gain or loss on Mint's records at year-end for
this transaction will be:
A. $500 loss
B. $500 gain
C. $378 gain
Risk?
D. $5,500 loss How to avoid risk?
How to Avoid FX Risk? Use Forward Contract

A forward contract requires the purchase (or sale) of currency units at a future date at
the contracted exchange rate.

10/1/X1 12/31/X1 4/1/X2

Transaction Balance sheet Settlement

date date date

Incur 5,000 yen liability. Obtain 5,000 yen through forward

exchange contract.
Sign 180-day forward exchange
contract to receive yen. (i.e. Buy Pay 5,000 yen to settle liability.
forward Contract)
Some Concepts: Spot Rate vs. Forward Rate

Spot Rate:
The exchange rate that is available today

Why?
Forward Rate:
1. The exchange rate that can be locked in today for an expected future
exchange transaction.
2. Expectations about the relative value of currencies are built into the forward
rate.
3. The actual spot rate at the future date may differ from todays forward rate.
Example: Spot Rate vs. Forward Rate

1. Mint Corporation has several

transactions with foreign entities. Each
transaction is denominated in the local
currency unit of the country in which the 180-day
foreign entity is located. On October 1, Forward rate = $1.4/yen
20X1, Mint purchased confectionary Spread = $0.2/
items from a foreign company at a price Spot rate = $1.30/yen
Spot rate = $1.20/yen
of Yen 5,000 when the direct exchange
rate was 1 Yen = $1.20. The account was
settled as of April 1, 20X2. Assume that 10/1/X1 4/1/X2
the exchange rate as of 12/31/20x1 were 1
Yen = $1.10 and as of 4/1/20x2 1 Yen = $ Do we know Spot
1.30. The foreign exchange gain or loss on rate of 4/1/X2 as of
Mint's records at year-end for this 10/1/X1?
transaction will be:
Forward (Exchange) Contract

General
1. Contracted through a dealer, usually a bank.
2. Possibly customized to meet contracting companys terms and needs.
3. Typically no margin deposit required.
4. Must be completed either with the underlyings future delivery or net cash
settlement.
Forward rate = Spot rate in the
Accounting for Forward Contract future?
1. A basic rule is fair value accounting
2. Changes in the fair value are recognized in the accounts, but the specific
accounting for the change depends on the purpose of the hedge.
3. For forward exchange contracts, the basic rule is to use the forward exchange
rate to value the forward contract.
How to Avoid FX Risk? Use Forward Contract

A forward contract requires the purchase (or sale) of currency units at a future date at
the contracted exchange rate.

10/1/X1 12/31/X1 4/1/X2

Transaction Balance sheet Settlement

date date date

Incur 5,000 yen liability. Obtain 5,000 yen through forward

exchange contract.
Sign 180-day forward exchange
contract to receive yen. (i.e. Buy Pay 5,000 yen to settle liability.
forward Contract)
Handout 2-1
10/1/X1 12/31/X1 4/1/X2

Transaction
date
Balance sheet
date
Settlement
date J/E?
Incur liability denominated in yen.
Pay yen to settle account payable.
1. Mint Corporation has several transactions with foreign entities. Each transaction is denominated in the local
currency unit of the country in which the foreign entity is located. On October 1, 20X1, Mint purchased
confectionary items from a foreign company at a price of Yen 5,000 when the direct exchange rate was 1 Yen =
$1.20. The account was settled as of April 1, 20X2. Mint decided to use forward contract to hedge the FX risks.
Assume that the exchange rates are as below.
Forward
Spot Rate
Date Rate to Apr. 1
Oct 1, 20x1 $1.20 $1.40
Dec 31, 20x1 $1.10 $1.15
April 1, 20x2 $1.30
Handout 2-2
Jaguar Co. (a U.S. -based company) sold parts to a Korean customer on December
16, 2015 with payment of 10 million Korean won to be received on January 15,
2016.

1. On 12/16, Buy or Sell Forward Contract?

2. On 12/31, Gain or Loss on Forward Contract?