Forward Exchange Contracts
While hedging can be accomplished with many different types of derivatives, in this chapter we focus mainly on hedging with the use of forward contracts. Later in this chapter, we illustrate the use of options as a hedging device.
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. At the inception of the contract, the forward rate normally varies from the spot rate. The difference between the two rates is referred to as a discount (premium) if the forward rate is less than (greater than) the spot rate, as shown here.
Which kind of forward contract to choose?
If the item being hedged is a foreign currency account payable, the firm should use a forward contract to purchase the foreign currency on the date the payable becomes due. This implies that the firm can lock in the cost of acquiring the foreign currency on the date the forward contract is acquired and subsequent changes in the exchange rate will not affect the amount the firm has to pay. One the other hand, if the item being hedged is a foreign currency accounts receivable, the firm should use a forward contract to sell the foreign currency on the date the receivable is expected to be collected.
The valuation of a forward contract (intrinsic versus time value): Forward contracts are valued on a net basis. For example, consider the following. Suppose on January 1, 2005, you obtain a one-year forward contract to sell 10,000 Canadian dollars using the December 31, 2005 forward rate of $1.50. This forward rate is the best guess to estimate what the spot rate will be on December 31, 2005. Therefore on January 1, 2005, you believe that 10,000 Canadian dollars will be worth $15,000. The forward contract locks in the amount of cash you will receive, $15,000. But since on January 1 this is also the expected cost to obtain Canadian dollars, the value of the forward contract is zero on this date and it will remain zero until the forward rate for December 31, 2005 settlement changes. Assume the following additional information:
With this forward contract, the amount of dollars to be received is fixed at $15,000, but the amount paid to acquire the foreign currency alters with changes in the exchange rate. What conditions will cause the contract to be beneficial to the firm? If the future spot rate falls below the forward rate on the forward contract, the firm will benefit. Looking at the data in retrospect, this is a valuable forward contract for the firm because the forward contract locks in the cash received at the $1.50 rate but the firm can purchase the currency on the settlement date at a spot rate of $1.44 (see the numbers in bold). In other words, the firm pays $1.44 to get $1.50. But on the date the forward contract is acquired, there is no guarantee that the firm will benefit from the contract (i.e. the spot rate on the settlement date might increase above $1.50).
Note that as the settlement date for the forward contract approaches, the forward rate converges to the settlement date spot rate. Also, note that the premium changes over time but eventually will become zero on the settlement date. What is the value of the forward on July 1, 2005? The amount of cash received from the forward is fixed at $15,000, but now the forward rate for December 31 settlement has changed to $1.48. This implies that we could enter into a contract to purchase the 10,000 Canadian dollars for $14,800. Thus the value of the forward has increased by $200 (the change in the forward rate). Similarly, on the settlement date, the forward rate drops to $1.44. Now the 10,000 Canadian dollars can be purchased for $14,400 and the forward contract has increased in value by another $400. The total change in value of the forward contract from the inception to the settlement date can be computed by taking the difference between the original forward rate of $1.50 and the spot rate on the settlement date ($1.44). In this example the forward contract increased in value by $600 or [($1.50-$1.44)(10,000)].
Notice that the initial premium is $0.10 and that the spot rate increased over the year by $0.04. The difference between these two equals the change in the value of the forward contract over the forward contract (in this case the premium represents a gain and the change in the spot rate is a loss). Since the premium will eventually be zero on the settlement date, the change in the premium (or discount) is known as the time element of the change in value of the forward contract. The change in the spot rate is considered the change in the intrinsic value of the forward. Thus the total change in value is equal to the sum of the intrinsic value and the time value (keep in mind that each of these changes in value can be positive or negative). This is summarized below.
(a) Definitions
The total change in the value of the forward contract = the change in the forward rates multiplied by the foreign currency,
The change in the intrinsic value of the forward contract = the change in the spot rate multiplied by the foreign currency, and
The change in the time value of the forward contract = the change in the premium multiplied by the foreign currency.
Why do forward rates differ from spot rates?
Forward rates for the purchase or sale of foreign currency, on some future date, can be higher, lower, or equal to the current spot rate on that currency. For instance, if the current spot rate for the exchange of pesos and dollars is $0.95, the forward rate to exchange pesos for dollars in one year might be higher or lower than $0.95 (it is unlikely to be equal). Why do these rates differ? The answer to this question involves differences in interest rates between the two countries. Suppose that the one-year forward rate and the current spot rate are equal but that in the US the cost of borrowing money for one year is 5% while in Mexico the cost of borrowing is 10%. A US company could take $9,500 and convert this amount into 10,000 pesos (at today’s spot rate) and invest this amount in Mexico at 10% for one year. This would accumulate to 11,000 pesos. At the same time, the firm could buy a forward contract to sell 11,000 pesos at the forward rate of $0.95 for $10,450. Assuming investments in the US and Mexico had equal risks and tax characteristics, this would amount to a risk-free 5% return (a 10% return in Mexico less 5% that could have been earned in the US). Investors would commit large sums of money to this investment. In our example, this process would tend to drive up US interest rates, drive down Mexican interest rates, and lower the forward rate. The equilibrium is known as interest rate parity. Therefore,
where i represents the interest rate and the superscript represents the country. Therefore, the forward rate that guarantees interest rate parity is $0.9068, or Forward rate = (1.05/1.10)($0.95) = $0.9068.
Then in the example above, the 11,000 pesos could only be converted into $9,975 enabling the US company to earn only 5% interest. Therefore, if the interest rate in the foreign country is higher than the rates in the US, the forward rate will be below the current spot rate. If the interest rate in the foreign country is lower than the rates in the US, the forward rate will be above the current spot rate.
There are a number of business situations in which a firm may desire to acquire a forward exchange contract. The uses of forward contracts include the following:
1. Hedges
a. Forward contracts used as a hedge of a foreign currency transaction. These include importing and exporting transactions denominated in foreign currency. These hedges do not qualify for hedge accounting under FASB 133 because the foreign exchange gains and losses are already reported in earnings under FASB 52, and the payables and receivables are reported at market value on the balance sheet.
b. Forward contracts used as a hedge of an unrecognized firm commitment (a fair-value hedge). An example of an unrecognized firm commitment would be when the firm enters into a contract to purchase an asset in two months for a fixed amount of foreign currency. Since the exchange rate may change over the next two months, the firm might use a forward contract to hedge the potential change in value of the purchased asset. Hedge accounting rules apply. Both the change in value of the hedge and the value of the hedged item are reported in earnings (before the contract is reported on the books). This is illustrated later.
c. Forward contract used as a hedge of a foreign currency denominated ‘forecasted’ transaction (a cash flow hedge). A forecasted transaction is a situation where the firm has planned sales receipts (expected to occur in the near future), and uses the forward contract as a means to hedge the cash flow risk. Initially, foreign exchange gains and losses are reported in comprehensive income while no offsetting amount is reported for the hedged item. Eventually, the exchange gains and losses will be reported in earnings in the period the hedged item affects earnings (i.e. if the item being hedged is a forecasted purchase of inventory, the gains and losses on the hedge will be reclassified into earnings when the inventory is sold).
d. Forward contracts as a hedge of a net investment in foreign operations.
2. Speculation
Forward contracts used to speculate changes in foreign currency.
The classifications above are important because the accounting for a particular type of forward contract depends on the purpose for which it was obtained. The difference in accounting relates primarily to two questions.
1. How is a transaction gain or loss on the forward contract computed and when should the gain or loss be reported?
2. What value should be reported for the forward contract in the financial statements over the life of the contract?
Hedges of forecasted foreign currency transaction may include some intercompany transactions. The hedging of foreign currency intercompany cash flows with foreign currency options is not uncommon. Because of its belief that the accounting for all derivative instruments should be the same, the FASB broadened the scope of hedges that are eligible for hedge accounting (as specified in FASB 138). If an intercompany foreign currency derivative is created, it can only be a hedging instrument in the consolidated financial statements if the other member enters an offsetting contract with an outside (unaffiliated) party to hedge its exposure; this restriction applies because the standards require that some component with foreign currency exposure must be a party to the hedging transaction. In the stand-alone statements of the subsidiary, however, the intercompany derivative could be designated as a hedge in the absence of third-party involvement. Therefore intercompany derivatives can be classified as either fair value or cash flow hedges if they meet the definition for that particular hedge and if the member of the consolidated group not using the intercompany derivative as a hedge enters into a derivative with an unrelated party to offset the original exposure from the intercompany hedge.
While hedging can be accomplished with many different types of derivatives, in this chapter we focus mainly on hedging with the use of forward contracts. Later in this chapter, we illustrate the use of options as a hedging device.
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. At the inception of the contract, the forward rate normally varies from the spot rate. The difference between the two rates is referred to as a discount (premium) if the forward rate is less than (greater than) the spot rate, as shown here.
|
|
Exchange
Rate
|
|
|
|
Forward rate
|
$.175
|
|
|
|
|
|
.007 premium
|
|
|
Spot rate
|
.168
|
|
|
|
|
|
.006 discount
|
|
|
Forward rate
|
.162
|
|
|
If the item being hedged is a foreign currency account payable, the firm should use a forward contract to purchase the foreign currency on the date the payable becomes due. This implies that the firm can lock in the cost of acquiring the foreign currency on the date the forward contract is acquired and subsequent changes in the exchange rate will not affect the amount the firm has to pay. One the other hand, if the item being hedged is a foreign currency accounts receivable, the firm should use a forward contract to sell the foreign currency on the date the receivable is expected to be collected.
The valuation of a forward contract (intrinsic versus time value): Forward contracts are valued on a net basis. For example, consider the following. Suppose on January 1, 2005, you obtain a one-year forward contract to sell 10,000 Canadian dollars using the December 31, 2005 forward rate of $1.50. This forward rate is the best guess to estimate what the spot rate will be on December 31, 2005. Therefore on January 1, 2005, you believe that 10,000 Canadian dollars will be worth $15,000. The forward contract locks in the amount of cash you will receive, $15,000. But since on January 1 this is also the expected cost to obtain Canadian dollars, the value of the forward contract is zero on this date and it will remain zero until the forward rate for December 31, 2005 settlement changes. Assume the following additional information:
Forward
Rate :
Date Spot Rate For 12/31/05 Settlement Premium
1/1/2005 $1.40 $1.50 $0.10
7/1/2005 $1.43 $1.48 $0.05
12/31/2005 $1.44 $1.44 $0.00
With this forward contract, the amount of dollars to be received is fixed at $15,000, but the amount paid to acquire the foreign currency alters with changes in the exchange rate. What conditions will cause the contract to be beneficial to the firm? If the future spot rate falls below the forward rate on the forward contract, the firm will benefit. Looking at the data in retrospect, this is a valuable forward contract for the firm because the forward contract locks in the cash received at the $1.50 rate but the firm can purchase the currency on the settlement date at a spot rate of $1.44 (see the numbers in bold). In other words, the firm pays $1.44 to get $1.50. But on the date the forward contract is acquired, there is no guarantee that the firm will benefit from the contract (i.e. the spot rate on the settlement date might increase above $1.50).
Note that as the settlement date for the forward contract approaches, the forward rate converges to the settlement date spot rate. Also, note that the premium changes over time but eventually will become zero on the settlement date. What is the value of the forward on July 1, 2005? The amount of cash received from the forward is fixed at $15,000, but now the forward rate for December 31 settlement has changed to $1.48. This implies that we could enter into a contract to purchase the 10,000 Canadian dollars for $14,800. Thus the value of the forward has increased by $200 (the change in the forward rate). Similarly, on the settlement date, the forward rate drops to $1.44. Now the 10,000 Canadian dollars can be purchased for $14,400 and the forward contract has increased in value by another $400. The total change in value of the forward contract from the inception to the settlement date can be computed by taking the difference between the original forward rate of $1.50 and the spot rate on the settlement date ($1.44). In this example the forward contract increased in value by $600 or [($1.50-$1.44)(10,000)].
Notice that the initial premium is $0.10 and that the spot rate increased over the year by $0.04. The difference between these two equals the change in the value of the forward contract over the forward contract (in this case the premium represents a gain and the change in the spot rate is a loss). Since the premium will eventually be zero on the settlement date, the change in the premium (or discount) is known as the time element of the change in value of the forward contract. The change in the spot rate is considered the change in the intrinsic value of the forward. Thus the total change in value is equal to the sum of the intrinsic value and the time value (keep in mind that each of these changes in value can be positive or negative). This is summarized below.
Forward
Rate Change
in Value(a)
For
12/31/05 Total Intrinsic Time
Date Spot
Rate Settlement Premium Value Value Value
1/1/2005 $1.40 $1.50 $0.10
7/1/2005 $1.43 $1.48 $0.05 $0.02 ($0.03) $0.05
12/31/2005 $1.44 $1.44 $0.00 $0.04 ($0.01) $0.05
Total change in rates and premium $0.06 ($0.04) $0.10
Foreign currency (Canadian dollars) 10,000 10,000 10,000
Total change in value in dollars (a) $600 ($400) $1,000
(a) Definitions
The total change in the value of the forward contract = the change in the forward rates multiplied by the foreign currency,
The change in the intrinsic value of the forward contract = the change in the spot rate multiplied by the foreign currency, and
The change in the time value of the forward contract = the change in the premium multiplied by the foreign currency.
Why do forward rates differ from spot rates?
Forward rates for the purchase or sale of foreign currency, on some future date, can be higher, lower, or equal to the current spot rate on that currency. For instance, if the current spot rate for the exchange of pesos and dollars is $0.95, the forward rate to exchange pesos for dollars in one year might be higher or lower than $0.95 (it is unlikely to be equal). Why do these rates differ? The answer to this question involves differences in interest rates between the two countries. Suppose that the one-year forward rate and the current spot rate are equal but that in the US the cost of borrowing money for one year is 5% while in Mexico the cost of borrowing is 10%. A US company could take $9,500 and convert this amount into 10,000 pesos (at today’s spot rate) and invest this amount in Mexico at 10% for one year. This would accumulate to 11,000 pesos. At the same time, the firm could buy a forward contract to sell 11,000 pesos at the forward rate of $0.95 for $10,450. Assuming investments in the US and Mexico had equal risks and tax characteristics, this would amount to a risk-free 5% return (a 10% return in Mexico less 5% that could have been earned in the US). Investors would commit large sums of money to this investment. In our example, this process would tend to drive up US interest rates, drive down Mexican interest rates, and lower the forward rate. The equilibrium is known as interest rate parity. Therefore,
where i represents the interest rate and the superscript represents the country. Therefore, the forward rate that guarantees interest rate parity is $0.9068, or Forward rate = (1.05/1.10)($0.95) = $0.9068.
Then in the example above, the 11,000 pesos could only be converted into $9,975 enabling the US company to earn only 5% interest. Therefore, if the interest rate in the foreign country is higher than the rates in the US, the forward rate will be below the current spot rate. If the interest rate in the foreign country is lower than the rates in the US, the forward rate will be above the current spot rate.
There are a number of business situations in which a firm may desire to acquire a forward exchange contract. The uses of forward contracts include the following:
1. Hedges
a. Forward contracts used as a hedge of a foreign currency transaction. These include importing and exporting transactions denominated in foreign currency. These hedges do not qualify for hedge accounting under FASB 133 because the foreign exchange gains and losses are already reported in earnings under FASB 52, and the payables and receivables are reported at market value on the balance sheet.
b. Forward contracts used as a hedge of an unrecognized firm commitment (a fair-value hedge). An example of an unrecognized firm commitment would be when the firm enters into a contract to purchase an asset in two months for a fixed amount of foreign currency. Since the exchange rate may change over the next two months, the firm might use a forward contract to hedge the potential change in value of the purchased asset. Hedge accounting rules apply. Both the change in value of the hedge and the value of the hedged item are reported in earnings (before the contract is reported on the books). This is illustrated later.
c. Forward contract used as a hedge of a foreign currency denominated ‘forecasted’ transaction (a cash flow hedge). A forecasted transaction is a situation where the firm has planned sales receipts (expected to occur in the near future), and uses the forward contract as a means to hedge the cash flow risk. Initially, foreign exchange gains and losses are reported in comprehensive income while no offsetting amount is reported for the hedged item. Eventually, the exchange gains and losses will be reported in earnings in the period the hedged item affects earnings (i.e. if the item being hedged is a forecasted purchase of inventory, the gains and losses on the hedge will be reclassified into earnings when the inventory is sold).
d. Forward contracts as a hedge of a net investment in foreign operations.
2. Speculation
Forward contracts used to speculate changes in foreign currency.
The classifications above are important because the accounting for a particular type of forward contract depends on the purpose for which it was obtained. The difference in accounting relates primarily to two questions.
1. How is a transaction gain or loss on the forward contract computed and when should the gain or loss be reported?
2. What value should be reported for the forward contract in the financial statements over the life of the contract?
Hedges of forecasted foreign currency transaction may include some intercompany transactions. The hedging of foreign currency intercompany cash flows with foreign currency options is not uncommon. Because of its belief that the accounting for all derivative instruments should be the same, the FASB broadened the scope of hedges that are eligible for hedge accounting (as specified in FASB 138). If an intercompany foreign currency derivative is created, it can only be a hedging instrument in the consolidated financial statements if the other member enters an offsetting contract with an outside (unaffiliated) party to hedge its exposure; this restriction applies because the standards require that some component with foreign currency exposure must be a party to the hedging transaction. In the stand-alone statements of the subsidiary, however, the intercompany derivative could be designated as a hedge in the absence of third-party involvement. Therefore intercompany derivatives can be classified as either fair value or cash flow hedges if they meet the definition for that particular hedge and if the member of the consolidated group not using the intercompany derivative as a hedge enters into a derivative with an unrelated party to offset the original exposure from the intercompany hedge.