Slide 17-1 17 CHAPTER 17 USING DERIVATIVES TO MANAGE FOREIGN CURRENCY EXPOSURES
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Slide 17-1
17 CHAPTER 17
USING DERIVATIVES TO MANAGE FOREIGN CURRENCY
EXPOSURES
Slide 17-2
17Focus of Chapter 17
Types of Foreign Exchange (FX) Exposure
The Concept and Technique of Hedging
Using FX Options to Hedge Using FX Forwards to Hedge Derivative Financial Instruments--
In General
Slide 17-3
17 The Technique of Hedging: A Way to Eliminate Risk
Creating a counterbalancing position to an FX exposure.
A loss on the exposed item will be offset by a gain on the counterbalancing position.
Slide 17-4
17 To Hedge or Not to Hedge: That Is the Question
Hedging is like taking an umbrella with youin case it rains.
Slide 17-5
17 The Technique of Hedging:The Alternative is Risky
Not hedging an FX exposure is
gambling that the exchange rate
will not change adversely.
Slide 17-6
17
FAS 133 Hedging Categories:“The Four Amigos”
Undesignated Hedges
Fair Value Hedges
Cash Flow Hedges
Net Investment Hedges
Slide 17-7
17
FAS 133 Hedging Categories :Nature of Each Category
Undesignated Hedges: FX receivables & FX payables from exporting and importing.
Fair Value Hedges: Firm commitments& hedges of certain assets and liabilities.
Cash Flow Hedges: Forecasted transactions & hedges of certain assets and liabilities.
Net Investment Hedges: Investmentsin foreign subsidiaries (covered in Ch. 18).
Slide 17-8
17
FAS 133 Hedging Categories :Manner of Valuing Hedging Contracts
For all 4 categories:Value the contract (an asset or liability depending on the situation) at fair value.Use quotes or present value of future cash flows.
Slide 17-9
17 Undesignated Hedges:Reporting FX Gains & Losses
Report ALL FX gains and
losses currently in earnings
as they arise.
Thus no special accounting treatment (i.e., no “hedge accounting”).
Slide 17-10
17 Fair Value Hedges:Reporting FX Gains & Losses
Report ALL FX gains and losses currently in earnings as they arise.
Simultaneously, recognize in earnings an FX loss or gainon the hedged item.This is a special accounting treatment (“hedge accounting”).
Slide 17-11
17 Cash Flow Hedges:Reporting FX Gains & Losses
Report ALL FX gains and losses currently in OCI as they arise.
When the hedged item is recorded in earnings, transfer the OCI item to earnings.This is a special accounting treatment (“hedge accounting”).
Slide 17-12
17 Net Investment Hedges:Reporting FX Gains & Losses
Report ALL FX gains and losses currently in OCI as they arise.
When the foreign sub is disposed of, transfer the OCI item to earnings (discussed in Chapter 18).This is a special accounting treatment (“hedge accounting”).
Slide 17-13
17 FX Option Contracts: Definition of An FX Option
A contractual agreement whereby one party grants another party the right to: Buy or sell a given quantity of
currency. At a specified exchange rate (for a
fee). During a specified future period.
Slide 17-14
17
FX Option Contracts: Terminology--Contracting Parties
The two parties to an option contract are the
writer and the holder (purchaser).
Writer’s perspective: A written option. Holder’s perspective: A purchased
option.
&
Slide 17-15
17
FX Option Contracts: Any Company Can Be a Writer
The Typical Situation: The writer is the FX trading
department of an international bank. The holder is an importer or exporter.
The Infrequent Situation: The writer is a nonbank corporation. The holder is a corporation.
Slide 17-16
17 FX Option Contracts: Terminology--Calls and Puts
There are two kinds of options:
Call: An option to buy.
Put: An option to sell.
Slide 17-17
17FX Option Contracts: Terminology--Exercise/Strike Prices
Exercise price means the
same as strike price.
=
Slide 17-18
17 FX Option Contracts: To Walk Away or Not Walk Away
The holder can always “walk away.”
The writer can never walk away.
Slide 17-19
17
FX Option Contracts: Compared With Stock Options
In an employee stock option:
The company is the writer.
The employee is the holder.
The employee can only have a gain. The company cannot have a reportable
loss--but will have less cash than it would have had if the stock had been issued at its current FV at the exercise date.
Slide 17-20
17
FX Options: One-Sided Exposure--I Win & You Lose
The holder can ONLY GAIN (less premium paid).
The writer can ONLY LOSE(less premium earned).
The holder’s GAIN always equalsthe writer’s LOSS.
Both parties can break even(but usually do not).
Slide 17-21
17 FX Option Contracts: The Net Result
A Zero-Sum Game:
$33,000 + $(33,000) = $ -0-Holder’s GAIN = Writer’s LOSS
Holder Writer NET
Slide 17-22
17
FX Option Contracts: Hopes & Dreams--The Holder’s Objective
The option holder (purchaser) hopes to:
Buy low & sell high.
Call Put Sell at .... $40 $40 Ex. PriceBuy at..... 30 Ex. Price 30 GAIN.... $10 $10
Slide 17-23
17
FX Option Contracts: Hopes & Dreams--The Writer’s Objective
The option writer hopes that:
The holder “takes a walk” (does not exercise the option).
Slide 17-24
17 FX Options: Premiums--Paid on the “Front End”
The option holder pays a premium to the option
writer--at the inception of the contract.
The premium compensates the option writer for the exchange risk the writer will incur.
The premium is the cost of buying insurance.
Slide 17-25
17 FX Options: Premiums--To Be “Amortized” Off of the Books
Premiums (always paid at the contract inception )
are capitalized as assets. This asset must be reduced to a zero value by
the contract expiration date.
Thus the option holder must AMORTIZE the premium offof its books over the life of the contract (the opposite of the accruing process).
Slide 17-26
17
FX Options:Premiums--A “Time Value” Element
Premiums are called a time value
element. Typically, the time value element
loses its value as a result of the
passage of time.
Slide 17-27
17
FX Options: How to Subsequently Value the “Time Value” Element
Method #1: Adjust to its fair value (obtainable from market quotes).FAS 133 requires this method.
Method #2: Amortize off of the books using the straight-line method. Was allowed prior to FAS 133.
Slide 17-28
17
FX Options:The “Intrinsic Value” Element
A favorable change in the exchange
rate creates intrinsic value--
the option is “in the money.”
Slide 17-29
17
FX Options: How to Subsequently Value the “Intrinsic Value” Element
Method #1: Adjust to its fair value (obtainable from market quotes).FAS 133 requires this method.
Method #2: Determine by the change
in the spot rate . Allowed prior to FAS 133.
Slide 17-30
17
FX Options: Relative Importanceof The Two Elements
The “Intrinsic value” element is the elephant.
The “time value” element is the elephant’s tail.
Slide 17-31
17 FX Options:Split Accounting--Defined
Split Accounting: Accounting for the “intrinsic value” element separately from the “time value” element.
Recall that the term “accounting” encompasses both : How to value an asset or liability and How to report that change in value (such
as (1) in earnings, (2) in OCI , or (3) a deferred charge or deferred credit ).
Slide 17-32
17
FX Options:Split Accounting--Possibilities
Split Accounting Possibilities: Intrinsic Time Value ValueVALUE the contract: The same way. . . . . . . . . . . . A A Differently. . . . . . . . . . . . . . . A BREPORT the change in value : The same way . . . . . . . . . . . . X X Differently. . . . . . . . . . . . . . . . X Y
Slide 17-33
17
FX Options: Split Accounting-- Requirements of FAS 133
Intrinsic Time Value ValueRequires the identical manner of VALUING. . . . . . FV FVRequires identical REPORTING for “undesignated” hedges In In & “fair value” hedges . . . . . . Earnings EarningsPermits different REPORTING for “cash flow” hedges & or In In OCI “net investment” hedges. . . . OCI Earnings
Slide 17-34
17 FX Forwards:Noncancelable Contracts
Legal description: A contractual agreement to exchange currencies at: A specified future date. A specified exchange rate.
Substance: A noncancelable purchase order for a commodity--currency.
Nature: EXECUTORY--BOTH parties execute at the settlement (delivery) date.
3/22/X5
$1.37
Slide 17-35
17
FX Forwards:Labeling the Parties To a Forward
Each party is referred to
as a “counterparty.”
Under the two-options view, however, each party to a forward exchange contract is viewed as being
BOTH a writer and a holder.
Slide 17-36
17
FX Forwards: Both Parties Must Execute (Deliver)
Each party must deliver a currency to the other party.
No “walkingaway”(as for FX options).Walking
Slide 17-37
17
FX Forwards: Two-Sided Exposure--I Win & You Lose--You Win & I Lose
Each counterparty can have a GAIN or a LOSS.
One party’s GAIN equals the other party’s LOSS. BOTH parties cannot have:
A GAIN at the same time.A LOSS at the same time.
Slide 17-38
17 FX Forwards:The Net Result
A Zero-Sum Game:
$33,000 + $(33,000) = $ -0- Hedger’s GAIN = FX Dealer’s LOSS
$(22,000) + $22,000 = $ -0- Hedger’s LOSS = FX Dealer’s GAIN
I. Hedging Party FX Dealer NET
II. Hedging Party FX Dealer NET
Slide 17-39
17FX Forwards: Whether to Buy or Sell To Hedge
“Try to remember...”: Method #1 -- “Buy-Buy” and
“Sell-Sell”: If buying inventory, buy forward
to hedge. If selling inventory, sell forward
to hedge.
Slide 17-40
17
FX Forwards: Whether to Buy or Sell To Hedge--The Long and Short of It
“Try to remember...”: Method #2-- “Do the OPPOSITE”
(used by FX traders). If buying inventory
(creates an FX Payable[a “short“ position] ) GO “LONG”
If selling inventory(creates an FX Receivable[a “long“ position] ) GO “SHORT”
Slide 17-41
17
FX Forwards: Better to Buy Low & Sell High Than Vice-Verse
BuyingForward
SellingForward
Forward rate (the fixed “locked into”) price: Buying rate..................... Selling rate......................
$1.75 $1.75
Spot rate at settlement date: Buying rate..................... Selling rate...................... $1.70
$1.70
Gain (Loss) on FX forward.. $ (.05) $ .05
Slide 17-42
17FX Forwards: Premiums and
Discounts--to Be Accrued Premiums and discounts are paid
at the tail-end of the contract--
the settlement date (also
called the “delivery” date). Each party ACCRUES--not amortizes--the premium or discount
onto the books over the contract life.
Slide 17-43
17
FX Forwards: Premiums & Discounts--Income or Expense?
Buying at a:
Premium = Unfavorable = Decrease Discount = Favorable = Increase
Selling at a:
Premium = Favorable = Increase Discount = Unfavorable = Decrease
Impact on Equity
Slide 17-44
17
FX Forwards: Premiums and Discounts--A “Time Value” Element
Premiums and discounts are a
“time value” element. Typically, the time value element
“decreases in value” as a result
of the passage of time.
Slide 17-45
17
FX Forwards: How to Subsequently Value the “Time Value “ Element
Method #1: Adjust to its fair value.FAS 133 requires this method.
Method #2: Accrue onto the books using the straight-line method. Was allowed prior to FAS 133.
Slide 17-46
17
FX Forwards:The “Intrinsic Value” Element
A change in the exchange rate creates
intrinsic value. Favorable change = An Asset
Unfavorable change = A Liability
Slide 17-47
17
FX Forwards: How to Subsequently Value the “Intrinsic Value” Element
Method #1: Adjust to its fair value (using present value of future cash
flows).FAS 133 requires this method.
Method #2: Determine by the change in the spot rate . Allowed prior to FAS 133 .
Slide 17-48
17
FX Forwards: Relative Importanceof The Two Elements
The “Intrinsic value” element is the elephant.
The “time value” element is the elephant’s tail .
Slide 17-49
17 FX Forwards:Split Accounting--Defined
Split Accounting: Accounting for the “intrinsic value” element separately from the “time value” element.
Recall that the term “accounting” encompasses both : How to value an asset or liability and How to report that change in value (such
as (1) in earnings, (2) in OCI , or (3) a deferred charge or deferred credit ).
Slide 17-50
17
FX Forwards:Split Accounting--Possibilities
Split Accounting Possibilities: Intrinsic Time Value ValueVALUE the contract: The same way. . . . . . . . . . . . A A Differently. . . . . . . . . . . . . . . A BREPORT the change in value : The same way . . . . . . . . . . . . X X Differently. . . . . . . . . . . . . . . . X Y
Slide 17-51
17
FX Forwards: Split Accounting-- Requirements of FAS 133
Intrinsic Time Value ValueRequires the identical manner of VALUING. . . . . . FV FVRequires identical REPORTING for “undesignated” hedges In In & “fair value” hedges . . . . . . Earnings EarningsPermits different REPORTING for “cash flow” hedges & In In OCI or
“net investment” hedges. . . . OCI Earnings
Slide 17-52
17
FX Forwards: Speculating--It’s Not for The Faint of Heart
A Noncounterbalancing Situation: Either a gain or a loss
occurs--never an offsetting gain and loss.
Slide 17-53
17
FX Forwards: Speculating--Ignore the Spot Rate--Use the Forward Rate
Nonsplit accounting:
Adjust to the quoted
forward rate--for the remaining life of the contract--at each financial reporting date (achieves current value accounting).
Slide 17-54
17FX Forwards: Crossing Over The Hedged Item’s Transaction Date
After the Transaction Date: Recognize all FX Gains & Losses
currently in earnings.
Before the Transaction Date: Recognize all FX Gains & Losses currently in
earnings. Simultaneously recognize FX Gains &
Losses on FX Commitments in earnings.
Slide 17-55
17Derivatives in General
Derivative defined: An executory contract (to be
executed or performed later by both parties), the value of which depends on the changes in another measure of value (often referred to as the “underlying” item).
Slide 17-56
17 Derivatives in General: Types of Underlying Items
The underlying items from which derivatives derive their value are: Rates Indexes Financial instruments Commodities
Dow Jones, Standard & Poors 500
Oil
French franc .......$.23 (4/1/X8)
Slide 17-57
17 Derivatives in General:Valuation and Nature
Valuation: Derivatives are valued in the balance
sheet at each financial reporting date at market value.
Nature: Derivatives can be characterized as a
“zero-sum game” because of their “what one party gains, the other party loses” nature.
Slide 17-58
17 Derivatives in General:Types of Risk
Three risks in derivatives:#1: MARKET RISK
An asset could decrease in value.A liability could increase in value.
Either way, equity goes down.
Slide 17-59
17 Derivatives in General:Market Risk
The party to a derivative whose position can become negative has unlimited market risk.
Market risk encompasses BOTH: “Balance-sheet risk” “Off-balance-sheet risk”
Slide 17-60
17 Derivatives in General:Types of Risk
Three risks in derivatives:#2: CREDIT RISK
Creditors have it.
AMOUNT OWED
Slide 17-61
17 Derivatives in General:Types of Risk
Three risks in derivatives:#3: LIQUIDITY RISK (“got CASH?”)Debtors have it.
Slide 17-62
17
Relationship of Credit Riskand Liquidity Risk--The Same Coin
Credit risk and liquidity risk are
“opposite sides of the same coin.”
The creditor can’t collect unless the debtor is LIQUID.
Slide 17-63
17End of Chapter 17
Time to Clear Things Up--Any Questions?
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