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Lecture 7

ACCT 4300 Lecture Notes - Lecture 7: Foreign Exchange Spot, Foreign Exchange Risk, Forward Contract


Department
Accounting
Course Code
ACCT 4300
Professor
Mc Comb
Lecture
7

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Foreign Currency Exchange Thursday, September 15
Sale or purchase of a product that is denominated in a foreign currency
Example notes:
Purchase
Spot rate: what the currency is trading for today
Entries always have to be entered as dollars at the US dollar value at the prevailing exchange rate
when the transaction occurs
- Entered in as dollars (how much it is worth), mark next to A/P that it is in Euros
Adjust to spot rate for YE and pay date
- Debit foreign exchange loss, Credit payable
Counterparty: bank or exchange house that converts foreign currencies
A forward contract can be an asset or a liability and is reported on the balance sheet
- The first time it is recorded is when
- Compare values with hedging and without hedging
- Value of forward contract: position at 12/31 is the amount due at the forward rate on the
transaction date
- If there was a new forward contract, we would pay the new rate at 12/31 times the amount
owed
- The difference is the value of the forward contract
At an interim date if there is time left on a foreign contract, we calculate the absolute value of the
foreign contract and discount it by the PV of money
Class Notes Thursday, September 22
1) Calc asset/liab fair value by multiplying transaction times the spot rate for all three dates
2) Calc change in fair value, D1 original amount D2 = D2-D1, D3 = D3-D2
3) Calculate forward contract benefit
a. Rec/pay trans. Amt times forward contract rate on transaction date AR value at settlement
date
b. Calc forward rate value for 12/31 (interim date) transaction amt * 12/31 forward rate
c. Benefit = 12/1 12/31 (negative indicates a liability)
4) Forward contract fair value
a. D2 = benefit *discount rate
b. D3= forward rate on this date compared to transaction amount under contract; current date
so it is not discounted
5) 12/1 JE (transaction date)
- DR AR/Expense; CR AP/Revenue (amount of transaction times the spot rate on transaction date)
6) 12/31 JEs (interim date)
- Record FX gain (AR & Gain) or FX loss (Loss & AP) = amt. of change in fair value of transaction
- Record FC gain (AOCI & Gain) or FC Loss (Loss & AOCI) opposite of the gain/loss from FX =
same value as above
- Record foreign contract (AOCI & forward contract for a liability) = fair value amount of forward
contract on 12/31
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- Record discount/premium (discount expense/AOCI or AOCI/premium revenue). Compare
contract to what would happen if we were paid on the transaction date (spot rate to forward
rate on transaction date). Premium rev for sales; disc exp for expenses = forward rate spot
rate amortized over life of contract
7) 3/1 JEs (settlement date)
- Record gain/loss = new transaction change in fair value
- Reverse entry: loss/gain on forward & AR/AP = same amount as above
- Adjust forward contract to fair value: AOCI/Forward Contract (increase in liability aka forward
contract) = change in FC fair value on chart at 12/31
- Adjust premium rev/discount to reflect a second month: AOCI & PR/DE &AOCI = y1 amount * 2
- Record receipt of foreign currency: Foreign currency & AR / AP & Foreign currency for amount it
is valued at on 3/1 (spot rate)
- Record receipt of cash ($): Cash, forward contract & foreign currency = cash is the amt. of fx
received stated on the contract, FC is the amount of the forward contract, foreign currency is
the amount of foreign currency at the spot rate
Zimbra Case Notes October 11, 2016
If we do not hedge, we could lose money because the spot rate may increase (cost more to buy
crowns)
Firm Commitment- Only record inventory in a payable when we receive inventory
- No entry on 12/1
- O /, there’s o payale etry
Forward Contract xxx
Gain on Forward Contract
Loss on firm commitment
Firm commitment
- On 1/31/y2,
Loss on Forward Contract xxx
Forward Contract
Firm commitment
Gain on firm commitment
Foreign currency (crowns)
Cash
Forward Contract
Inventory
Foreign currency
Firm commitment
Adjustment to net income
Fair value: calculate the amount of transaction * option premium
Intrinsic value (profit/benefit): strike price = spot rate, no intrinsic value
Fair value = intrinsic + time (plug)
Accounts payable (call option)
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Class Notes Thursday, October 13
Payable = call options
Receivable = put options
Textbook Notes
I. Foreign Currency Exchange Markets
A. Exchange Rate Mechanisms
1. Independent float: the value of the currency is allowed to fluctuate freely according to
market forces, with little or no intervention from the central bank
2. Pegged to another currency: the value of the currency is fixed (pegged) in terms of a
particular foreign currency, and the central bank intervenes as necessary to maintain
the fixed value.
3. European monetary system (euro): the value of the euro floats against other currencies
such as the US dollar.
B. Spot and Forward Rates
1. The spot rate is the price at which a foreign currency can be purchased or sold today.
2. A forward rate is the price today at which foreign currency can be purchased or sold
sometime in the future.
a. Has advantages for businesses when prices are tending to increase
b. A forward rate can exceed the spot rate on a given date, which is said to be selling
at a premium. If the forward rate is less than the spot rate, it is a discount (also
applies to interest rates).
c. Unbiased predictors of the future spot rate
C. Option Contracts
1. Option contracts give currency holders the option of the right but not the obligation to
trade foreign currency in the future when there is a forward rate.
a. Put option: sale of currency by the holder of the option
b. Call option: purchase of foreign currency by the holder of the option
c. Strike price: exchange rate at which the option will be executed if the holder of the
option decides to execute the option (similar to a forward rate)
2. Unlike forward contracts where banks earn profit through the spread between buying
and selling rates, options must be purchased by paying a premium.
a. Intrinsic value: gain that could result by exercising the option immediately
b. Time value: spot rate could change and result in a loss of money
II. Foreign Currency Transactions
Foreign exchange risk: the risk that a company faces when giving a foreign country a period of time
to pay for a product or service that the value of the currency will decrease
Transaction exposure
- Export sale: exists when the exporter allows the buyer to pay in a foreign currency and to pay
some time after the sale has been made. The exporter is exposed to the risk that the foreign
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