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For the reporting year ended October, 2005, the Foreign Exchange Committee of the New York Federal Reserve Board reported that the average daily volume in OTC foreign exchange options totaled $37 billion
The Chicago Mercantile Exchange (CME) is the worlds largest and most diverse regulated foreign exchange trading market. CME is an international marketplace that brings together buyers and sellers on its CME Globex electronic trading platform and on its trading floors.
In 2005, over 84 million foreign exchange contracts with a notional value of $10.2 trillion dollars traded at CME. In May, 2006, CME foreign exchange products averaged a record 501,000 contacts per day, up 69% from the year earlier Electronic foreign exchange products set monthly records of 451,000 contracts per day, an increase of 90% from the previous year.
International Accounting & Multinational Enterprises Chapter 13 Radebaugh, Gray, Black
Managing foreign exchange risk is a critical function, and as companies become more global, managing this risk becomes increasingly important
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
Swaps
Example: Assume a U.S. company has received a dividend from a subsidiary in the E.U., but has no use of the euros for 30 days. They could deposit the euros in a French bank and earn interest for 30 days. Alternatively, they could convert the euros to dollars and also enter into a forward contract with the bank to deliver dollars in 30 days en exchange for euros at the forward exchange rate.
International Accounting & Multinational Enterprises Chapter 13 Radebaugh, Gray, Black
Variation: Foreign currency swap that is driven by interest rate differentials. Japanese company would like to borrow U.S. dollars at a floating rate. U.S. company would like to borrow yen at a fixed rate. A financial intermediary pairs the two companies. The Japanese company issues a fixed rate bond and turns the yen over to the U.S. company. The U.S. company issues a floating rate obligation, and turns the dollars over to the Japanese company. The swap exchange rate is the rate at which the tow companies agree to exchange yen for dollars.
Futures
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, NOT tailored to the specific needs of the company (forward contract) Less valuable to a company than a forward contract May be useful to speculators and small companies that may not be able to negotiate a forward contract Contract months are March, June, Sept., Dec. Less flexible than forward contracts
Options
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
Writer sells the option Holder buys the option, pays a premium to the writer
Option can be a put or a call A put option gives the holder the right to sell foreign currency to the writer of the option A call option gives the holder the right to buy foreign currency from the writer of the option The cost is the contract cost and a brokerage fee
International Accounting & Multinational Enterprises Chapter 13 Radebaugh, Gray, Black
The contract cost is nonrefundable If the contract is not exercised, the option writer retains the option price
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
Most widely traded instrument is swaps, followed by spot transactions and outright forwards
International Monetary Fund (IMF) created in 1944 to promote exchange stability Exchange Rate Arrangements 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, Belize 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 The euro, pound, and yen float, but the yuan is pegged to a market basked of currencies.
Fisher Effect A theory describing the long-run relationship between inflation and interest rates. This equation tells us that, all things being equal, a rise in a country's expected inflation rate will eventually cause an equal rise in the interest rate (and vice versa). 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
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
Lower inflation
stronger currency
The forward rate differs from the spot rate by a percentage equal to the interest rate differential. If monetary units can earn more interest in euros over a 90 day period than if the monetary units are maintained in dollars, this interest rate differential will be impounded in the difference between the spot rate and the forward rate. The forward rate is also an unbiased predictor of the spot rate that will exist in the future, which means that it is neither systematically above or below the actual future spot rate.
Political issues can change exchange rate differentials, particularly in the short run
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
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
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
Current rate method is likely to have an exposed asset position all assets and liabilities translate at the same rate; assets exceed liabilites Temporal method is likely to have an exposed liability position most liabilities translate at the current rate, while some assets translate at the current rate and some translate at the historical rate. 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
Economic exposure is the potential for change in expected cash flows Economic exposure arises from
Superior Products Inc., a U.S. company, found that prices for valves it was sourcing from Germany were continuing to rise. As a result, Superiors 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.
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
Duffeys 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
Financial Strategies
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
More complicated and costly than financial hedges Involved in betting on the exposure of the entire firm rather than just specific financial transactions 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.
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
Differentiate between transactions, translation, and economic exposure Each type of exposure may require a different hedging response
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
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
Dell Example
Dell hedges everything Dells Brazilian operations hedge about 80% of forecasted revenues
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
Hedging Standards
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
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 Redexs 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
June 30
1,500 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
1,550,000
Nominal Value FV Mar 1 0 0 Mar 31 ($15,000) ($14,925) Apr 30 ($20,000) ($20,000) Fair Value adjustment on March 31 15,000/[1 + (.06/12)] = 14,925
March 31
Other comprehensive income 14,925 Forward contract 14,925 Other comprehensive income 5,075 Forward contract 5,075
Foreign currency Sales 1,510,000 1,510,000
April 30
April 30
20,000
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.
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
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
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 Fair-value hedges Cash-flow hedges Foreign currency hedges
International Accounting & Multinational Enterprises Chapter 13 Radebaugh, Gray, Black