Derivatives and Foreign Currency
1. Define the term derivative and provide examples of risks that derivative contracts are designed to reduce.
Derivative is the name given to a broad range of financial securities. Their common characteristic is that the derivative contract’s 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.
2. Explain the differences between forward contracts and futures contracts and the potential benefits and potential costs of each type of contract.
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.
3. Explain the differences between options and swaps and the potential benefits and potential costs of each type of contract.
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.
4. What does “Net Settlement” mean?
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.
5. Distinguish between measurement and denomination in a particular currency.
A transaction is measured in a particular currency if its magnitude is expressed in that currency. A transaction is measured in a particular currency when it is recorded in the financial records in that currency. Assets and liabilities are denominated in a currency if their amounts are fixed in terms of that currency, and they are settled with that currency.
6. Assume that one euro can be exchanged for 1.20 U.S. dollars. What is the exchange rate if the exchange rate is quoted directly? Indirectly?
Direct quotation: 1.20/1 = $1.20
Indirect quotation: 1/1.20 = .83 euros per dollar
7. What is the difference between official and floating foreign exchange rates? Does the United States have floating exchange rates?
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.
8. What is a spot rate with respect to foreign currency transactions? Could a spot rate ever be a historical rate? Could a spot rate ever be a fixed exchange rate? Discuss.
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.
9. Assume that a U.S. corporation imports electronic equipment from Japan in a transaction denominated in U.S. dollars. Is this transaction a foreign currency transaction? A foreign transaction? Explain the difference between these two concepts and their application here.
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. How are assets and liabilities denominated in foreign currency measured and recorded at the transaction date? At the balance sheet date?
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.
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. Criticize the following statement: “Exchange losses arise from foreign import activities, and exchange gains arise from foreign export activities.”
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. When are exchange gains and losses reflected in a business’s financial statements?
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. A U.S. corporation imported merchandise from a British company for £1,000 when the spot rate was $1.45. It issued financial statements when the current rate was $1.47, and it paid for the merchandise when the spot rate was $1.46. What amount of exchange gain or loss will be included in the U.S. corporation’s income statements in the period of purchase and in the period of settlement?
There will be a $20 exchange loss in the period of purchase and a $10 exchange gain in the period of settlement:
Billing date
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Inventory
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$1,450
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Accounts payable (fc)
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$1,450
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Year-end adjustment
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Exchange loss
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$ 20
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Accounts payable (fc)
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$ 20
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Settlement date
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Accounts payable (fc)
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$1,470
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Cash
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$1,460
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Exchange gain
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10
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