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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 dollars. If a U.S. exporter 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 cus- tomers will decrease as the dollar strengthens. If ex- port 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 perhaps less attractive to foreign cus- tomers. 2. If the U.S. dollar is weakening against the FC, then more dollars will be required to settle FC pur- chases and exchange losses will be experienced. 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 ex- actly how many dollars it will take to secure the ne- cessary FC. As the value of the payable to the for- eign vendor increases 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 ef- fective 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 subject to change and 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 increases, future gross profits decrease. This risk could be effectively hedged if the U.S. company se- cured 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 commit- ment 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 income (OCI), rather than in current earnings. When the forecasted transaction actually occurs, it will at some point in time have an effect on earnings. In the case of purchased equip- ment, the effect on earnings will be recognized as
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This note was uploaded on 04/07/2008 for the course ACCT. 3533 taught by Professor Jahanian during the Spring '08 term at Temple.

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