06 - CHAPTER 6 UNDERSTANDING THE ISSUES 1. If the U.S....

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CHAPTER 6 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 dollars. If a U.S. export- er of goods and services generates sales that are denominated in FC, they will be exposed to exchange rate risk. The dollar equivalent of the FC received from export customers will de- crease as the dollar strengthens. If export sales are denominated in U.S. dollars, then foreign 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 perhaps 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 experi- enced. These losses could be hedged against through the use of a forward contract to buy FC. Given a fixed forward 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 resulting 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 offsetting the effects of a weakening U.S. dollar. 3. A commitment to purchase inventory payable in FC is characterized by a fixed number of FCs. However, the exchange rate for the FC is sub- ject to change; therefore, the commitment may cost the purchaser more or less equivalent dollars as rates change. The commitment to purchase would become 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 pur- chase increases, future gross profits decrease. This risk could be effectively hedged if the U.S. company secured the right to acquire the ne- cessary 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 trans- action date. The losses on the commitment could be offset by gains on the hedging instru- ments. 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 adjust- ment would reduce the cost of the inventory and allow for otherwise increased profit mar- gins. 4. The cash flow hedging instrument would be measured at fair value with changes prior to the transaction date being recognized as a com- ponent of other comprehensive income (OCI), rather than in current earnings. When the fore- casted transaction actually occurs, it will at some point in time have an effect on earnings. In the case of purchased equipment, the effect
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This note was uploaded on 12/17/2011 for the course ACC 400 STBSBA73 taught by Professor Gilbertrodriguez during the Spring '09 term at University of Phoenix.

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06 - CHAPTER 6 UNDERSTANDING THE ISSUES 1. If the U.S....

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