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12-1
12
Accounting for Foreign Currency
Transactions and Hedging
Foreign Exchange Risk

Advanced Accounting, Fifth Edition

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Learning Objectives

1. Distinguish between the terms “measured” and


“denominated.”

2. Describe what is meant by a foreign currency transaction.

3. Understand some of the more common foreign currency


transactions.

4. Identify three stages of concern to accountants for


foreign currency transactions, and explain the steps used to
translate foreign currency transactions for each stage.

5. Describe a forward exchange contract.

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Learning Objectives

6. Explain the use of forward contracts as a hedge of an


unrecognized firm commitment.

7. Identify some of the common situations in which a forward


exchange contract can be used as a hedge.

8. Describe a derivative instrument and understand how it may


be used as a hedge.

9. Explain how exchange gains and losses are reported for fair
value hedges and cash flow hedges.

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Foreign Currency Transactions

Many U.S. companies engage in international activities


such as:
Exporting or importing goods,

Establishing a foreign branch, or

Holding an equity investment in a foreign company.

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Foreign Currency Transactions

Recording and reporting problems with foreign currency


transactions:
Transactions in a foreign currency must be translated
(expressed in dollars) before they can be aggregated
with domestic transactions.
Receivables or payables denominated in foreign
currencies are subject to gains and losses.
Companies use hedging strategies with derivatives to
minimize the impact of exchange rate changes.

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Exchange Rates—Means of Translation

Translation - process of expressing amounts stated in


a foreign currency in the currency of the reporting
entity by using an appropriate exchange rate.

Exchange rate - ratio between a unit of one currency


and another currency for which that unit can be
exchanged at a particular time.

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Exchange Rates—Means of Translation

Direct Exchange Rate


Units of domestic currency that can be converted into
one unit of foreign currency.
Direct rate = 1.517 ($1.517 U.S. for 1 British pound)

Indirect Exchange Rate


Units of foreign currency that can be converted into
one unit of domestic currency.
Indirect rate = 1.00/1.517 = .6592
($1 U.S. for .6592 British pound)

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Exchange Rates—Means of Translation

Spot Rate
Rate at which currencies can be exchanged today.

Forward or Future Rate


Rate at which currencies can be exchanged at some
future date.

Forward Exchange Contract


Contract to exchange currencies of different
countries on a stipulated future date, at a specified
rate (the forward rate).

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Exchange Rates—Means of Translation
Floating Rates
Relationship between major currencies is determined
by supply and demand factors.

Increase risk to companies doing business with a


foreign company.

Example – Payable to be settled in 100,000 yen


Transaction Change Settlement
Date in Rate Date
Yen 100,000 100,000
Direct rate $ 0.00434 $ 0.00625
Payable $ 434.00 $ 625.00
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Measured Versus Denominated

Transactions are normally measured and recorded in


terms of the currency in which the reporting entity
prepares its financial statements.
Reporting Currency - usually the currency where the
company is located.
Transaction between a U.S. firm and a foreign company:
Companies negotiate whether settlement is to be made in
dollars or in the foreign currency.
If settled by foreign currency, U.S. firm measures the
receivable or payable in dollars, but the transaction is
denominated in the foreign currency.

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LO 1 Measured versus denominated.
Foreign Currency Transactions

Foreign Currency Transaction - requires payment or


receipt (settlement) in a foreign currency.
U.S. firm exposed to risk of unfavorable changes in
the exchange rate.

Direct exchange rate More dollars needed to


increasing, or foreign = acquire the foreign
currency unit strengthening. currency units.

Direct exchange rate Fewer dollars needed to


decreasing, or foreign = acquire the foreign
currency unit weakening. currency units.

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LO 2 Foreign Currency Transactions.
Foreign Currency Transactions

Importing or Exporting of Goods or Services

Translating Accounts Denominated in Foreign Currency

Transaction Balance Settlement


date sheet date date

Units of foreign currency x Current direct exchange rate

Increase or decrease is generally reported as a foreign currency


transaction gain or loss, sometimes referred to as an exchange gain
or loss, in determining net income for the current period.

Slide LO 3 Common transactions.


12-13 LO 4 Three stages of concern.
Importing and Exporting Transactions

Exercise 12-2: During December of the current year,


Teletex Systems, Inc., a company based in Seattle,
Washington, entered into the following transactions:

Dec. 10 Sold seven office computers to a company located


in Colombia for 8,541,000 pesos. On this date, the
spot rate was 365 pesos per U.S. dollar.

Inventory delivered
12/10/Year 1
U.S. firm
Columbia firm
(Teletex)
8,541,000 pesos
received on 1/10/Year 2
Slide LO 3 Common transactions.
12-14 LO 4 Three stages of concern.
Importing and Exporting Transactions

Exercise 12-2: Dec. 10, Sold seven office computers to a


company located in Colombia for 8,541,000 pesos. On this
date, the spot rate was 365 pesos per U.S. dollar. Prepare the
journal entry on the books of Teletex Systems, Inc. (periodic
method)

Accounts receivable 23,400


Sales 23,400

Sales price in pesos 8,541,000


Pesos per U.S. dollar / 365
Sales price in U.S. dollars $ 23,400

Slide LO 3 Common transactions.


12-15 LO 4 Three stages of concern.
Importing and Exporting Transactions

Exercise 12-2: Prepare journal entry necessary to adjust


the accounts as of December 31. Assume that on December
31 the direct exchange rates was Colombia peso $.00268.

Transaction loss 510


Accounts receivable 510

Receivable in pesos 8,541,000


Direct exchange rate to U.S. dollar $ .00268
Receivable in U.S. dollars $ 22,890
Balance in receivable 23,400
Transaction loss $ 510
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12-16 LO 3 Common transactions. LO 4 Three stages of concern.
Importing and Exporting Transactions

Exercise 12-2: Prepare journal entry to record settlement of


the account on January 10. Assume that the direct exchange
rate on the settlement date was Colombia peso $.00320.

Cash (8,541,000 x $.00320) 27,331


Accounts receivable ($23,400 - $510) 22,890
Transaction gain 4,441

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12-17 LO 3 Common transactions. LO 4 Three stages of concern.
Importing and Exporting Transactions

Exercise 12-2: During December of the current year,


Teletex Systems, Inc., a company based in Seattle,
Washington, entered into the following transactions:
Dec. 12 Purchased computer chips from a Taiwan company.
Contract was denominated in 500,000 Taiwan dollars.
Direct exchange rate on this date was $.0391.

Inventory received
12/12/Year 1
U.S. firm
Taiwan firm
(Teletex)
500,000 Taiwan dollars
paid on 1/10/Year 2
Slide LO 3 Common transactions.
12-18 LO 4 Three stages of concern.
Importing and Exporting Transactions

Exercise 12-2: Dec. 12, Purchased computer chips from a


company domiciled in Taiwan. The contract was denominated
in 500,000 Taiwan dollars. The direct exchange spot rate on
this date was $.0391. Prepare the journal entry on the books
of Teletex Systems, Inc.

Purchases 19,550
Accounts payable 19,550

Purchase price in Taiwan dollars 500,000


Direct exchange rate to U.S. dollar x $.0391
Purchase price in U.S. dollars $ 19,550

Slide LO 3 Common transactions.


12-19 LO 4 Three stages of concern.
Importing and Exporting Transactions

Exercise 12-2: Prepare journal entry necessary to adjust


the account as of December 31. Assume that on December 31
the direct exchange rates was Taiwan dollar $.0351.

Accounts payable 2,000


Transaction gain 2,000

Payable in pesos 500,000


Direct exchange rate to U.S. dollar $ .0351
Payable in U.S. dollars $ 17,550
Balance in payable 19,550
Transaction gain $ 2,000
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12-20 LO 3 Common transactions. LO 4 Three stages of concern.
Importing and Exporting Transactions

Exercise 12-2: Prepare journal entry to record settlement


of account on January 10. Assume that the direct exchange
rate on the settlement date was Taiwan dollar $.0398.

Transaction loss 2,350


Accounts payable ($19,550 - $2,000) 17,550
Cash (500,000 x $.0398) 19,900

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12-21 LO 3 Common transactions. LO 4 Three stages of concern.
Importing and Exporting Transactions

Importing or Exporting of Goods or Services


Foreign currency transaction gains and losses are
included in net income.
Two-transaction approach:
The sale or purchase is viewed as a transaction separate
from the financing arrangement.
The dollar amount recorded (in Sales or in Purchases) is
determined by the exchange rate on the transaction date.
Adjustments to the foreign-currency-denominated
receivable or payable are recorded directly to the
transaction gain or loss and included in net income.

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12-22 LO 3 Common transactions. LO 4 Three stages of concern.
Importing and Exporting Transactions

Hedging Foreign Exchange Rate Risk


Derivative Instrument - a financial instrument that
provides the holder (or writer) with the right (or obligation)
to participate in some or all of the price changes of another
underlying value of measure, but does not require the holder
to own or deliver the underlying value of measure.

Two broad categories: Derivatives are recognized in the


Forward-based balance sheet at their fair value,
Option-based resulting in a payable position for
one party and a receivable
position for the other.
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LO 8 Derivatives as a hedge.
Importing and Exporting Transactions

Forward Exchange Contracts


A forward exchange contract (forward contract) is an
agreement to exchange currencies of two different countries
at a specified rate (the forward rate) on a stipulated
future date.

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12-24 LO 5 Forward exchange contracts.
Importing and Exporting Transactions

Which Kind of Forward Contract to Choose?


1. Forward Contract used as a Hedge of a(n):
a. Foreign currency transaction.
b. Unrecognized firm commitment (a fair value hedge).
c. Foreign-currency-denominated “forecasted”
transaction (a cash flow hedge).
d. Net investment in foreign operations.

2. Speculation
Forward contracts used to speculate changes in foreign
currency.

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12-25 LO 5 Forward exchange contracts.
Using Forward Contracts as a Hedge

Hedge of a Foreign Currency Exposed Liability


Problem 12-2: Christel Exporting Co. is a U.S. wholesaler
engaged in foreign trade. The following transaction is
representative of its business dealings. The company uses a
periodic inventory system and is on a calendar-year basis. All
exchange rates are direct quotations.

Dec. 1 Christel Exporting purchased merchandise from


Chang’s Ltd., a Hong Kong manufacturer. The invoice was for
210,000 Hong Kong dollars, payable on April 1. On this same
date, Christel Exporting acquired a forward contract to buy
210,000 Hong Kong dollars on April 1 for $.1314.

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12-26 LO 7 Forward contracts as a hedge.
Using Forward Contracts as a Hedge

Problem 12-2: (additional facts)

April 1 Christel Exporting submitted full payment of


210,000 Hong Kong dollars to Chang’s, Ltd., after obtaining
the 210,000 Hong Kong dollars on its forward contract.
Spot rates and the forward rates for the Hong Kong dollar
were as follows:
Forward Rate for
Spot Rate ($) April 1 Delivery ($)
Dec. 1 .1265 .1314
Dec. 29 .1240 .1305
Dec. 31 .1259 .1308
April 1 .1430
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12-27 LO 7 Forward contracts as a hedge.
Using Forward Contracts as a Hedge

Problem 12-2: Prepare journal entries for the transactions


including the necessary adjustments on December 31.

Dec 1 Purchases 26,565


Accounts Payable 26,565

Hong Kong dollars 210,000


Dec. 1 Direct Spot Rate $ .1265
Payable in U.S. dollars $ 26,565

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12-28 LO 7 Forward contracts as a hedge.
Using Forward Contracts as a Hedge

Problem 12-2: Prepare journal entries for the transactions


including the necessary adjustments on December 31.

Dec 1 FC Receivable from Exch. Dealer 27,594


Dollars Payable to Exch. Dealer 27,594

Hong Kong dollars 210,000


Dec. 1 Forward Rate $ .1314
Payable in U.S. dollars $ 27,594

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12-29 LO 7 Forward contracts as a hedge.
Using Forward Contracts as a Hedge

Problem 12-2: Prepare journal entries for the transactions


including the necessary adjustments on December 31.

Dec 31 Accounts Payable 126


Transaction Gain 126

Hong Kong dollars 210,000


Dec. 31 Spot Rate $ .1259
Payable in U.S. dollars $ 26,439
Payable recorded on Dec. 1 26,565
Transaction gain $ 126
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12-30 LO 7 Forward contracts as a hedge.
Using Forward Contracts as a Hedge

Problem 12-2: Prepare journal entries for the transactions


including the necessary adjustments on December 31.

Dec 31 Transaction Loss 126


FC Receivable from Exchange Dealer 126

Hong Kong dollars 210,000


Dec. 31 Forward Rate $ .1308
Payable in U.S. dollars $ 27,468
Payable recorded on Dec. 1 27,594
Transaction loss $ (126)
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12-31 LO 7 Forward contracts as a hedge.
Using Forward Contracts as a Hedge

Problem 12-2: Prepare journal entries for the transactions


including the necessary adjustments on December 31.

Dec 31 Transaction Loss 3,591


Accounts payable 3,591

Hong Kong dollars 210,000


Apr. 1 Spot Rate $ .1430
Payable in U.S. dollars $ 30,030
Payable established on Dec. 31 26,439
Transaction loss $ (3,591)
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12-32 LO 7 Forward contracts as a hedge.
Using Forward Contracts as a Hedge

Problem 12-2: Prepare journal entries for the transactions


including the necessary adjustments on December 31.

Dec 31 FC Receivable from Exch. Dealer 2,562


Transaction Gain 2,562

Hong Kong dollars 210,000


Apr. 1 Spot Rate $ .1430
Payable in U.S. dollars $ 30,030
Payable established on Dec. 31 27,468
Transaction loss $ 2,562
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12-33 LO 7 Forward contracts as a hedge.
Using Forward Contracts as a Hedge

Problem 12-2: Prepare journal entries for the transactions


including the necessary adjustments on December 31.

Apr 1 Investment in Foreign Currency 30,030


Dollars Payable to Exch. Dealer 27,594
Cash 27,594
FC Receivable from Exch. Dealer 30,030
(payment to dealer and receipt of 210,000 Hong Kong dollars)

Accounts Payable 30,030


Investment in Foreign Currency 30,030
(payment of liability upon transfer of 210,000 Hong Kong dollars)

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12-34 LO 7 Forward contracts as a hedge.
Using Forward Contracts as a Hedge

Problem 12-2: Transaction Summary

Transaction Transaction
Hedged Item Balance Gain/(Loss) Hedge Balance Gain/(Loss)
Accounts Payable FC Receivable
Dec. 1 $ 26,565 Dec. 1 $ 27,594
Dec. 31 26,439 $ 126 Dec. 31 27,468 $ (126)
Apr. 1 30,030 (3,591) Apr. 1 30,030 2,562
Total gain/(loss) $ (3,465) $ 2,436

Thus the net effect is a $1,029 loss when the


forward contract is used.

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12-35 LO 7 Forward contracts as a hedge.
Using Forward Contracts as a Hedge

Hedge of a Foreign Currency Exposed Asset


Accounting for a forward contract entered into as a hedge of
an exposed receivable position is similar to an exposed
liability position.

Because the U.S. firm will be receiving foreign currency in


settlement of the exposed receivable balance, it will enter
into a forward contract to sell foreign currency for U.S.
dollars.

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12-36 LO 7 Forward contracts as a hedge.
Using Forward Contracts as a Hedge

Fair Value Hedge—Hedging an Unrecognized Foreign


Currency Commitment

 A U.S. firm, at a date earlier than the transaction date,


may make a commitment to a foreign company to buy or
sell goods at a price established in foreign currency.

 Changes in the exchange rate between the commitment


date and transaction date would be reflected in the cost
or sales price of the asset.

 The U.S. firm may enter a forward contract to hedge its


commitment.

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12-37 LO 7 Forward contracts as a hedge.
Using Forward Contracts as a Hedge
Exercise 12-14: Consider the following information:
1. On December 1, 2008, a U.S. firm contracts to sell equipment
(with an asking price of 10,000 pesos) in Mexico. The firm will
take delivery and will pay for the equipment on March 1, 2009.
2. On December 1, 2008, the company enters into a forward
contract to sell 10,000 pesos for $9.48 on March 1, 2009.
3. Spot rates and the forward rates for March 1, 2009,
settlement were as follows (dollars per peso):
Spot Rate Forward Rate
December 1, 2008 $9.54 $9.48
Balance sheet date (12/31/08) 9.49 9.44
March 1, 2009 9.47
4. On March 1, the equipment was sold for 10,000 pesos. The cost
of the equipment was $40,000.
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12-38 LO 7 Forward contracts as a hedge.
Using Forward Contracts as a Hedge
Exercise 12-14: Prepare all journal entries needed on December
1, December 31, and March 1 to account for the forward contract,
the firm commitment, and the transaction to sell the equipment.

Dec 1 Receivable from Exchange Dealer* 94,800


FC Payable to Exchange Dealer 94,800

Dec 31 FC Payable from Exchange Dealer** 400


Foreign Exchange Gain 400

Foreign Exchange Loss 400


Firm Commitment** 400

* (10,000 x $9.48 = $94,800)


** [(10,000 x ($9.48 - $9.44)] = $400
Slide
12-39 LO 7 Forward contracts as a hedge.
Using Forward Contracts as a Hedge
Exercise 12-14: Prepare all journal entries needed on December
1, December 31, and March 1 to account for the forward contract,
the firm commitment, and the transaction to sell the equipment.

Mar 1 Foreign Exchange Loss 300


FC Payable from Exchange Dealer* 300

Firm Commitment* 300


Foreign Exchange Gain 300

Investment in FC 94,700
Firm Commitment 100
Sales (10,000 x 9.48) 94,800

* [(10,000 ´ ($9.44 - $9.47)] =$300


Slide
12-40 LO 7 Forward contracts as a hedge.
Using Forward Contracts as a Hedge
Exercise 12-14: Prepare all journal entries needed on December
1, December 31, and March 1 to account for the forward contract,
the firm commitment, and the transaction to sell the equipment.

Mar 1 Cash 94,800


FC Payable to Exchange Dealer 94,700
Investment in FC 94,700
Dollars Receivable from Exchange Dealer 94,800

Cost of Goods Sold 40,000


Inventory 40,000

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12-41 LO 7 Forward contracts as a hedge.
Using Forward Contracts as a Hedge

Cash Flow Hedge-A Forecasted Transaction


 Cash Flow Hedge - hedging cash flows for future
transactions that have not yet occurred or for which
there are no firm commitments.

 Cash flow hedges may defer the Income statement


recognition of gains and losses on forecasted transactions
if certain criteria are met.

 Amounts in accumulated other comprehensive income are


reclassified into earnings in the same period which the
hedged forecasted transaction affects earnings.
Slide
12-42 LO 7 Fair value hedge vs. cash flow hedge.
Using Forward Contracts as a Hedge
Exercise 12-13: Consider the following information:
1. On December 1, 2008, a U.S. firm plans to purchase a piece of
equipment (with an asking price of 100,000 francs) in
Switzerland during January of 2009. The transaction is
probable, and the transaction is to be denominated in euros.
2. On December 1, 2008, the company enters into a forward
contract to buy 100,000 francs for $1.01 on January 31, 2009.
3. Spot rates and the forward rates for January 31, 2009,
settlement were as follows (dollars per francs):
Spot Rate Forward Rate
December 1, 2008 $0.99 $1.01
Balance sheet date (12/31/08) 1.01 1.02
Jan. 31 and Feb. 1, 2009 1.04
4. On Feb. 1, the equipment was purchased for 100,000 francs.
Slide
12-43 LO 7 Fair value hedge vs. cash flow hedge.
Using Forward Contracts as a Hedge
Exercise 12-13: Prepare all journal entries needed on Dec. 1, Dec.
31, Jan. 31, and Feb. 1 to account for the forecasted transaction,
the forward contract, and the transaction to buy the equipment.

Dec.1 FC Receivable from Exchange Dealer 101,000


Dollars Payable to Exchange Dealer* 101,000

Dec.31 FC Receivable from Exchange Dealer** 1,000


Foreign Exchange Gain – OCI 1,000

* (100,000 x $1.01) = $101,000


** [(100,000 x ($1.01- $1.02)] = $1,000
Slide
12-44 LO 7 Fair value hedge vs. cash flow hedge.
Using Forward Contracts as a Hedge
Exercise 12-13: Prepare all journal entries needed on Dec. 1, Dec.
31, Jan. 31, and Feb. 1 to account for the forecasted transaction,
the forward contract, and the transaction to buy the equipment.

Jan.31 FC Receivable from Exchange Dealer 2,000


Foreign Exchange Gain – OCI 2,000
[(100,000 ´ ($1.02- $1.04)]

Investment in FC 104,000
Dollars Payable to Exchange Dealer 101,000
Cash 101,000
FC Receivable from Exchange Dealer 104,000
Feb. 1 Equipment 104,000
Investment in FC 104,000
Slide
12-45 LO 7 Fair value hedge vs. cash flow hedge.
Using Forward Contracts as a Hedge

Economic Hedge of a Net Investment in a


Foreign Entity
 A U.S. firm may enter into a foreign currency transaction
or a nonderivative financial instrument in an effort to
minimize or offset the effects of currency fluctuations
on an equity investment in a foreign company.

 The gain or loss on the hedging instrument is reported in


the same manner as the translation adjustment, that is,
reported in the cumulative translation adjustment section
under comprehensive income. FASB ASC paragraph 815-
35-35-1
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12-46 LO 7 Fair value hedge vs. cash flow hedge.
Using Forward Contracts as a Hedge

Forward Contracts Acquired to Speculate in the


Movement of Foreign Currencies
A forward contract may be acquired for speculative purposes
in anticipation of realizing a gain.

Disclosure Requirements of the Various Hedges


FASB ASC Section 815-20-50 specifies certain minimal
disclosures for derivative instruments and nonderivative
instruments designated as qualifying hedging instruments.

Slide LO 7 Fair value hedge vs. cash flow hedge.


12-47 LO 3 Common transactions.
Using Forward Contracts as a Hedge

Using Options to Hedge Foreign Currency Changes

 Options, give the holder the advantage of right but not


the obligation to buy or sell the currency.

 If the exchange rate changes in a negative manner, the


firm can simply let the option lapse without a loss.

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12-48 LO 8 Derivatives used as a hedge.
Copyright

Copyright © 2011 John Wiley & Sons, Inc. All rights reserved.
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