USING DERIVATIVES TO MANAGE FOREIGN CURRENCY EXPOSURES

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CHAPTER 17

• USING DERIVATIVES TO MANAGE FOREIGN CURRENCY
  EXPOSURES

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Focus 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

3
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.

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To Hedge or Not to Hedge That Is the Question

• Hedging is like taking an umbrella with youin
  case it rains.

5
The Technique of HedgingThe Alternative is
Risky

• Not hedging an FX exposure is gambling that the
  exchange rate will not change adversely.

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FAS 133 Hedging CategoriesThe Four Amigos

• Undesignated Hedges
• Fair Value Hedges
• Cash Flow Hedges
• Net Investment Hedges

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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).

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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.

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Undesignated HedgesReporting 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).

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Fair Value HedgesReporting 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).

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Cash Flow HedgesReporting 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).

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Net Investment HedgesReporting 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).

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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.

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FX Option Contracts Terminology--Contracting
Parties

• The two parties to an option contract are the
  writer and the holder (purchaser).
• Writers perspective A written option.
• Holders perspective A purchased option.

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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.

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FX Option Contracts Terminology--Calls and
Puts

• There are two kinds of options
• Call An option to buy.
• Put An option to sell.

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FX Option Contracts Terminology--Exercise/Strike
Prices

• Exercise price means the same as strike price.

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FX Option Contracts To Walk Away or Not Walk
Away

• The holder can always walk away.
• The writer can never walk away.

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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.

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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 holders GAIN always equalsthe writers
  LOSS.
• Both parties can break even(but usually do not).

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FX Option Contracts The Net Result

• A Zero-Sum Game 33,000
  (33,000) -0-
• Holders GAIN Writers LOSS

NET
Holder
Writer
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FX Option Contracts Hopes Dreams--The
Holders Objective

• The option holder (purchaser) hopes to
• Buy low sell high.

Call
Put Sell at .... 40 40
Ex. Price Buy at..... 30 Ex. Price 30
GAIN.... 10 10
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FX Option Contracts Hopes Dreams--The
Writers Objective

• The option writer hopes thatThe holder takes
  a walk (does not exercise the option).

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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.

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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).

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FX OptionsPremiums--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.

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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.

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FX OptionsThe Intrinsic Value Element

• A favorable change in the exchange rate creates
  intrinsic value--the option is in the money.

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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.

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FX Options Relative Importanceof The Two
Elements

• The Intrinsic value element is the
  elephant.
• The time value element is the elephants tail.

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FX OptionsSplit 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 ).

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FX OptionsSplit 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

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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

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FX ForwardsNoncancelable 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
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FX ForwardsLabeling 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.

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FX Forwards Both Parties Must Execute (Deliver)

• Each party must deliver a currency to the other
  party.
• No walkingaway(as for FX options).

Walking
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FX Forwards Two-Sided Exposure--I Win You
Lose--You Win I Lose

• Each counterparty can have a GAIN or a LOSS.
• One partys GAIN equals the other partys LOSS.
• BOTH parties cannot have
• A GAIN at the same time.
• A LOSS at the same time.

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FX ForwardsThe Net Result

• A Zero-Sum Game 33,000
  (33,000) -0-
• Hedgers GAIN FX Dealers LOSS(22,000)
  22,000 -0-
• Hedgers LOSS FX Dealers GAIN

I. Hedging Party FX Dealer
NET
II. Hedging Party FX Dealer
NET
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FX 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.

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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 Payablea
  short position ) GO LONG
• If selling inventory(creates an FX Receivablea
  long position ) GO SHORT

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FX Forwards Better to Buy Low Sell High Than
Vice-Verse
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FX Forwards Premiums and Discounts--to Be
Accrued

• Premiums and discounts are paidat the tail-end
  of the contract--the settlement date
  (alsocalled the delivery date).
• Each party ACCRUES--not amortizes--the premium or
  discountonto the books over the contract life.

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FX Forwards Premiums Discounts--Income or
Expense?
Impact on Equity

• Buying at a Premium Unfavorable
  Decrease Discount Favorable
  Increase
• Selling at a Premium Favorable
  Increase Discount Unfavorable
  Decrease

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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.

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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.

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FX ForwardsThe Intrinsic Value Element

• A change in the exchange rate creates intrinsic
  value.
• Favorable change An Asset
• Unfavorable change A Liability

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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 .

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FX Forwards Relative Importanceof The Two
Elements

• The Intrinsic value element is the
  elephant.
• The time value element is the elephants tail .

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FX ForwardsSplit 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 ).

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FX ForwardsSplit 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

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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

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FX Forwards Speculating--Its Not for The
Faint of Heart

• A Noncounterbalancing Situation
• Either a gain or a lossoccurs--never an
  offsetting gain and loss.

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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).

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FX Forwards Crossing Over The Hedged Items
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.

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Derivatives 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).

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Derivatives in General Types of Underlying Items

• The underlying items from which derivatives
  derive their value are
• Rates
• Indexes
• Financial instruments
• Commodities

French franc ........23 (4/1/X8)
Dow Jones, Standard Poors 500
Oil
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Derivatives in GeneralValuation 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.

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Derivatives in GeneralTypes 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.

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Derivatives in GeneralMarket 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

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Derivatives in GeneralTypes of Risk

• Three risks in derivatives
• 2 CREDIT RISK
• Creditors have it.

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Derivatives in GeneralTypes of Risk

• Three risks in derivatives
• 3 LIQUIDITY RISK (got CASH?)
• Debtors have it.

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Relationship of Credit Riskand Liquidity
Risk--The Same Coin

• Credit risk and liquidity risk are opposite
  sides of the same coin.
• The creditor cant collect unless the debtor is
  LIQUID.

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End of Chapter 17

• Time to Clear Things Up--Any Questions?