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Unformatted text preview: Chapter 06 - Foreign Currency Transactions and Hedging Foreign Exchange Risk CHAPTER 6 FOREIGN CURRENCY TRANSACTIONS AND HEDGING FOREIGN EXCHANGE RISK Chapter Outline I. There are a variety of exchange rate arrangements in use around the world. A majority of national currencies are allowed to fluctuate in value against other currencies over time. Some currencies are pegged in terms of another currency, often the U.S. dollar. A. The spot rate is the price at which a foreign currency can be purchased or sold today. B. The forward rate is the price that can be locked-in today at which foreign currency can be purchased or sold at a predetermined date in the future. C. Exchange rates can be stated as direct quotes (number of dollars per foreign currency unit) or indirect quotes (number of foreign currency units per dollar). II. A company can enter into a forward contract with its bank to fix the price at which it can buy or sell foreign currency at a specified future date. There is no up front cost to enter into a forward contract. When it matures, the forward contract must be honored, with the company buying or selling foreign currency at the predetermined forward rate. III. A company can purchase a foreign currency option that gives it the right, but not the obligation, to buy or sell foreign currency at a specified future date at a predetermined price (the strike price). The company purchases the option by paying an option premium. Upon maturity, the company can choose to exercise the option and buy or sell currency at the strike price, or allow the option to expire unexercised. A. The option premium (fair value of the option) is a function of two components: intrinsic value and time value. Intrinsic value is the gain that can be realized by exercising the option immediately (the difference between the strike price and the spot rate). An option with a positive intrinsic value is in the money. Time value relates to the fact that as time passes and the spot rate changes, the option might become more valuable. B. The value of a foreign currency option can be determined through the use of an option pricing formula, such as Black-Scholes. IV. Export sales and import purchases that are denominated in a foreign currency create exposure to foreign exchange risk. A. An increase in the value of a foreign currency will result in a foreign exchange gain on a foreign currency receivable and a foreign exchange loss on a foreign currency payable. B. Conversely, a decrease in the value of a foreign currency will result in a foreign exchange loss on a foreign currency receivable and a foreign exchange gain on a foreign currency payable. V. Foreign currency balances must be revalued to their current domestic currency equivalent using current exchange rates whenever financial statements are prepared....
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- Spring '11