CHAPTER 14 USING DERIVATIVES TO MANAGE FOREIGN CURRENCY

CHAPTER 14 USING DERIVATIVES TO MANAGE FOREIGN CURRENCY EXPOSURES

Focus of Chapter 14 • Types of Foreign Exchange (FX) Exposure • The Concept and Technique of Hedging • Using FX Options to Hedge • Using FX Forwards to Hedge • Derivative Financial Instruments— In General

The Technique of Hedging: A Way to Eliminate Risk • Creating a counterbalancing position to an FX exposure. • A loss on the exposed item will be offset by a gain on the counterbalancing position.

To Hedge or Not to Hedge: That Is the Question • Hedging is like taking an umbrella with you in case it rains.

The Technique of Hedging: The Alternative is Risky • Not hedging an FX exposure is gambling that the exchange rate will not change adversely.

FAS 133 Hedging Categories: “The Four Amigos” • Undesignated Hedges • Fair Value Hedges • Cash Flow Hedges • Net Investment Hedges

FAS 133 Hedging Categories: Nature of Each Category • Undesignated Hedges: FX receivables & FX payables from exporting and importing. • Fair Value Hedges: Firm commitments & hedges of certain assets and liabilities. • Cash Flow Hedges: Forecasted transactions & hedges of certain assets and liabilities. • Net Investment Hedges: Investments in foreign subsidiaries (covered in Ch. 18).

FAS 133 Hedging Categories: Manner of Valuing Hedging Contracts • For all 4 categories: – Value the contract (an asset or liability depending on the situation) at fair value. • Use quotes or present value of future cash flows.

Undesignated Hedges: Reporting FX Gains & Losses • Report ALL FX gains and losses currently in earnings as they arise. • Thus no special accounting treatment (i. e. , no “hedge accounting”).

Fair Value Hedges: Reporting FX Gains & Losses • Report ALL FX gains and losses currently in earnings as they arise. • Simultaneously, recognize in earnings an FX loss or gain on the hedged item. – This is a special accounting treatment (“hedge accounting”).

Cash Flow Hedges: Reporting FX Gains & Losses • Report ALL FX gains and losses currently in OCI as they arise. • When the hedged item is recorded in earnings, transfer the OCI item to earnings. – This is a special accounting treatment (“hedge accounting”).

Net Investment Hedges: Reporting FX Gains & Losses • Report ALL FX gains and losses currently in OCI as they arise. • When the foreign sub is disposed of, transfer the OCI item to earnings (discussed in Chapter 18). – This is a special accounting treatment (“hedge accounting”).

FX Option Contracts: Definition of An FX Option • A contractual agreement whereby one party grants another party the right to: – Buy or sell a given quantity of currency. – At a specified exchange rate (for a fee). – During a specified future period.

FX Option Contracts: Terminology—Contracting Parties • The two parties to an option contract are the writer and the holder (purchaser). • Writer’s perspective: A written option. • Holder’s perspective: A purchased option.

FX Option Contracts: Any Company Can Be a Writer • The Typical Situation: – The writer is the FX trading department of an international bank. – The holder is an importer or exporter. • The Infrequent Situation: – The writer is a nonbank corporation. – The holder is a corporation.

FX Option Contracts: Terminology—Calls and Puts • There are two kinds of options: – Call: An option to buy. – Put: An option to sell.

FX Option Contracts: Terminology—Exercise/Strike Prices • Exercise price means the same as strike price.

FX Option Contracts: To Walk Away or Not Walk Away • The holder can always “walk away. ” • The writer can never walk away.

FX Option Contracts: Compared With Stock Options • In an employee stock option: – The company is the writer. – The employee is the holder. – The employee can only have a gain. – The company cannot have a reportable loss—but will have less cash than it would have had if the stock had been issued at its current FV at the exercise date.

FX Options: One-Sided Exposure—I Win & You Lose • The holder can ONLY GAIN (less premium paid). • The writer can ONLY LOSE (less premium earned). • The holder’s GAIN always equals the writer’s LOSS. • Both parties can break even (but usually do not).

FX Option Contracts: The Net Result • A Zero-Sum Game: Holder Writer NET $33, 000 + $(33, 000) = $ -0– Holder’s GAIN = Writer’s LOSS

FX Option Contracts: Hopes & Dreams—The Holder’s Objective • The option holder (purchaser) hopes to: – Buy low & sell high. Call Put Sell at. . $40 Ex. Price Buy at. . . 30 Ex. Price 30 GAIN. . $10

FX Option Contracts: Hopes & Dreams—The Writer’s Objective • The option writer hopes that: The holder “takes a walk” (does not exercise the option).

FX Options: Premiums— Paid on the “Front End” • The option holder pays a premium to the option writer—at the inception of the contract. • The premium compensates the option writer for the exchange risk the writer will incur. • The premium is the cost of buying insurance.

FX Options: Premiums—To Be “Amortized” Off of the Books • Premiums (always paid at the contract inception) are capitalized as assets. • This asset must be reduced to a zero value by the contract expiration date. • Thus the option holder must AMORTIZE the premium off of its books over the life of the contract (the opposite of the accruing process).

FX Options: Premiums—A “Time Value” Element • Premiums are called a time value element. • Typically, the time value element loses its value as a result of the passage of time.

FX Options: How to Subsequently Value the “Time Value” Element • Method #1: Adjust to its fair value (obtainable from market quotes). – FAS 133 requires this method. • Method #2: Amortize off of the books using the straight-line method. – Was allowed prior to FAS 133.

FX Options: The “Intrinsic Value” Element • A favorable change in the exchange rate creates intrinsic value—the option is “in the money. ”

FX Options: How to Subsequently Value the “Intrinsic Value” Element • Method #1: Adjust to its fair value (obtainable from market quotes). – FAS 133 requires this method. • Method #2: Determine by the change in the spot rate. – Allowed prior to FAS 133.

FX Options: Relative Importance of The Two Elements • The “Intrinsic value” element is the elephant. • The “time value” element is the elephant’s tail.

FX Options: Split Accounting—Defined • Split Accounting: Accounting for the “intrinsic value” element separately from the “time value” element. • Recall that the term “accounting” encompasses both: – How to value an asset or liability and – How to report that change in value (such as (1) in earnings, (2) in OCI, or (3) a deferred charge or deferred credit ).

FX Options: Split Accounting—Possibilities Split Accounting Possibilities: Intrinsic VALUE the contract: Value The same way. . . A A Differently. . . . A B REPORT the change in value : The same way. . . X X Differently. . . . X Y Time Value

FX Options: Split Accounting— Requirements of FAS 133 Intrinsic Value Time Value Requires the identical manner of VALUING. . . FV FV Requires identical REPORTING for “undesignated” hedges In In & “fair value” hedges. . . Earnings Permits different REPORTING for “cash flow” hedges & or In In OCI “net investment” hedges. . OCI Earnings

FX Forwards: Noncancelable Contracts • Legal description: A contractual agreement to exchange currencies at: 3/22/X 6 – A specified future date. $1. 37 – A specified exchange rate. • Substance: A noncancelable purchase order for a commodity—currency. • Nature: EXECUTORY—BOTH parties execute at the settlement (delivery) date.

FX Forwards: Labeling the Parties To a Forward • Each party is referred to as a “counterparty. ” • Under the two-options view, however, each party to a forward exchange contract is viewed as being BOTH a writer and a holder.

FX Forwards: Both Parties Must Execute (Deliver) • Each party must deliver a currency to the other party. • No “walking away” (as for FX options).

FX Forwards: Two-Sided Exposure —I Win & You Lose—You Win & I Lose • Each counterparty can have a GAIN or a LOSS. • One party’s GAIN equals the other party’s LOSS. – BOTH parties cannot have: • A GAIN at the same time. • A LOSS at the same time.

FX Forwards: The Net Result A Zero-Sum Game: I. Hedging Party FX Dealer NET $33, 000 + $(33, 000) = $ -0– Hedger’s GAIN = FX Dealer’s LOSS II. Hedging Party FX Dealer NET $(22, 000) + $22, 000 = $ -0– Hedger’s LOSS = FX Dealer’s GAIN

FX Forwards: Whether to Buy or Sell To Hedge • “Try to remember. . . ”: – Method #1— “Buy-Buy” and “Sell”: • If buying inventory, buy forward to hedge. • If selling inventory, sell forward to hedge.

FX Forwards: Whether to Buy or Sell To Hedge—The Long and Short of It • “Try to remember. . . ”: – Method #2— “Do the OPPOSITE” (used by FX traders). • If buying inventory (creates an FX Payable [a “short“ position]) GO “LONG” • If selling inventory (creates an FX Receivable [a “long“ position]) GO “SHORT”

FX Forwards: Better to Buy Low & Sell High Than Vice-Verse

FX Forwards: Premiums and Discounts—to Be Accrued • Premiums and discounts are paid at the tailend of the contract—the settlement date (also called the “delivery” date). • Each party ACCRUES—not amortizes— the premium or discount onto the books over the contract life.

FX Forwards: Premiums & Discounts—Income or Expense? Impact on Equity • Buying at a: Premium = Unfavorable = Decrease Discount = Favorable = Increase • Selling at a: Premium = Favorable = Increase Discount = Unfavorable = Decrease

FX Forwards: Premiums and Discounts—A “Time Value” Element • Premiums and discounts are a “time value” element. • Typically, the time value element “decreases in value” as a result of the passage of time.

FX Forwards: How to Subsequently Value the “Time Value” Element • Method #1: Adjust to its fair value. – FAS 133 requires this method. • Method #2: Accrue onto the books using the straight-line method. – Was allowed prior to FAS 133.

FX Forwards: The “Intrinsic Value” Element • A change in the exchange rate creates intrinsic value. – Favorable change = An Asset – Unfavorable change = A Liability

FX Forwards: How to Subsequently Value the “Intrinsic Value” Element • Method #1: Adjust to its fair value (using present value of future cash flows). – FAS 133 requires this method. • Method #2: Determine by the change in the spot rate. – Allowed prior to FAS 133.

FX Forwards: Relative Importance of The Two Elements • The “Intrinsic value” element is the elephant. • The “time value” element is the elephant’s tail.

FX Forwards: Split Accounting—Defined • Split Accounting: Accounting for the “intrinsic value” element separately from the “time value” element. • Recall that the term “accounting” encompasses both: – How to value an asset or liability and – How to report that change in value (such as (1) in earnings, (2) in OCI, or (3) a deferred charge or deferred credit).

FX Forwards: Split Accounting—Possibilities • Split Accounting Possibilities: Intrinsic Time Value VALUE the contract: The same way. . . A A Differently. . . . A B REPORT the change in value : The same way. . . X X Differently. . . . X Y

FX Forwards: Split Accounting— Requirements of FAS 133 Intrinsic Value Time Value Requires the identical manner of VALUING. . . FV FV Requires identical REPORTING for “undesignated” hedges In In & “fair value” hedges. . . Earnings Permits different REPORTING for “cash flow” hedges &In In OCI or “net investment” hedges. . OCI Earnings

FX Forwards: Speculating— It’s Not for The Faint of Heart • A Noncounterbalancing Situation: – Either a gain or a loss occurs—never an offsetting gain and loss.

FX Forwards: Speculating—Ignore the Spot Rate—Use the Forward Rate • Nonsplit accounting: – Adjust to the quoted forward rate—for the remaining life of the contract—at each financial reporting date (achieves current value accounting).

FX Forwards: Crossing Over The Hedged Item’s Transaction Date • After the Transaction Date: – Recognize all FX Gains & Losses currently in earnings. • Before the Transaction Date: – Recognize all FX Gains & Losses currently in earnings. – Simultaneously recognize FX Gains & Losses on FX Commitments in earnings.

Derivatives in General • Derivative defined: – An executory contract (to be executed or performed later by both parties), the value of which depends on the changes in another measure of value (often referred to as the “underlying” item).

Derivatives in General: Types of Underlying Items • The underlying items from which derivatives derive their value are: – Rates French franc. . . . $. 23 (4/1/X 6) – Indexes Dow Jones, Standard & Poors 500 – Financial instruments – Commodities

Derivatives in General: Valuation and Nature • Valuation: – Derivatives are valued in the balance sheet at each financial reporting date at market value. • Nature: – Derivatives can be characterized as a “zero-sum game” because of their “what one party gains, the other party loses” nature.

Derivatives in General: Types of Risk • Three risks in derivatives: – #1: MARKET RISK • An asset could decrease in value. • A liability could increase in value. – Either way, equity goes down.

Derivatives in General: Market Risk • The party to a derivative whose position can become negative has unlimited market risk. • Market risk encompasses BOTH: – “Balance-sheet risk” – “Off-balance-sheet risk”

Derivatives in General: Types of Risk • Three risks in derivatives: – #2: CREDIT RISK • Creditors have it.

Derivatives in General: Types of Risk • Three risks in derivatives: – #3: LIQUIDITY RISK (“got CASH? ”) • Debtors have it.

Relationship of Credit Risk and Liquidity Risk—The Same Coin • Credit risk and liquidity risk are “opposite sides of the same coin. ” • The creditor can’t collect unless the debtor is LIQUID.

End of Chapter 14 • Time to Clear Things Up—Any Questions?