13_Fischer10e_SM_Ch10_final

13_Fischer10e_SM_Ch10_final - CHAPTER 10 UNDERSTANDING THE...

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CHAPTER 10 UNDERSTANDING THE ISSUES 1. If the U.S. dollar strengthens relative to a FC, this means that the dollar commands more FC. The direct exchange rate will change in that 1 FC will be worth fewer dol- lars. If a U.S. exporter of goods and ser- vices generates sales that are denominated in FC, they will be exposed to exchange rate risk. The dollar equivalent of the FC re- ceived from export customers will decrease as the dollar strengthens. If export sales are denominated in U.S. dollars, then for- eign customers will have to give up more of their FC in order to acquire the necessary dollars. This means that U.S. goods and services would be more expensive and per- haps less attractive to foreign customers. 2. If the U.S. dollar is weakening against the FC, then more dollars will be required to settle FC purchases and exchange losses will be experienced. These losses could be hedged against through the use of a for- ward contract to buy FC. Given a fixed for- ward rate, the holder of the contract will know exactly how many dollars it will take to secure the necessary FC. As the value of the payable to the foreign vendor in- creases with resulting losses, the value of the forward contract will increase with res- ulting gains. Both the transaction losses and hedging gains will be recognized in current earnings. If the hedge is properly structured, it could be highly effective in off- setting the effects of a weakening U.S. dol- lar. 3. A commitment to purchase inventory pay- able in FC is characterized by a fixed num- ber of FCs. However, the exchange rate for the FC is subject to change; therefore, the commitment may cost the purchaser more or less equivalent dollars as rates change. The commitment to purchase would be- come less attractive if the number of dollars needed to acquire the fixed number of FCs increases over time. This would be the case if the dollar weakened relative to the FC. As the dollar cost of the purchase in- creases, future gross profits decrease. This risk could be effectively hedged if the U.S. company secured the right to acquire the necessary FC at a fixed rate. Such a hedge could be accomplished through the use of a forward contract or option to buy FC at the future transaction date. The losses on the commitment could be offset by gains on the hedging instruments. Furthermore, the firm commitment account would then be used to adjust the basis of the acquired inventory at the date of the actual purchase transaction. The basis adjustment would reduce the cost of the inventory and allow for other- wise increased profit margins. 4. The cash flow hedging instrument would be measured at fair value with changes prior to the transaction date being recognized as a component of other comprehensive in- come (OCI), rather than in current earn- ings. When the forecasted transaction actu- ally occurs, it will at some point in time have an effect on earnings. In the case of purchased equipment, the effect on earn-
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13_Fischer10e_SM_Ch10_final - CHAPTER 10 UNDERSTANDING THE...

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