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Unformatted text preview: Advanced Accounting Foreign Currency Transactions Continued A. Hedging an Existing Foreign Currency Transaction with a Forward Contract 1. The objective of such a hedge is to offset the change in fair value of the asset or liability denominated in the foreign currency with the change in value of the hedging instrument. 2. For example, suppose a U.S. corporation acquires inventory from a British vendor with payment due in British pounds. Concurrently, the U.S. company enters into a forward contract to purchase British pounds. 3. If prior to settlement, the U.S. dollar weakens relative to the British pound, accounts payable will increase in value and an exchange loss will result. However, at the same time, the forward contract to buy British pounds, which is an asset, will increase in value if the dollar weakens. 4. The fair market value of a forward purchase contract is the difference between the contracted forward rate and the current forward rate for delivery on the contracted date. 5. For example, on April 1, 20X6, a U.S. corporation enters into a forward contract to purchase 100,000 Canadian dollars for $.70 per Canadian dollar on June 1, 20X6. The contract has no value on April 1 because the contracted rate equals the forward rate for delivery on June 1. Suppose that on May 1, the forward rate for delivery of Canadian dollars is $.72. Therefore, the fair value of the forward contract on May 1 is calculated as follows: ($.72 - .70) X 100,000 Canadian dollars = $2,000. Thus, the value of the forward contract changes as the forward rate for the contracted delivery date changes. 6. To be completely accurate, since the forward contract involves cash flows that will occur in the future, the difference between the current forward rate and the contracted rate should be discounted to its present value. We will assume that the effect of discounting is immaterial....
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This note was uploaded on 03/08/2012 for the course ACCT 401 taught by Professor Staff during the Summer '08 term at Texas A&M.
- Summer '08