A foreign exchange hedge (FOREX hedge) is a method used by companies to eliminate or (US GAAP).
Foreign exchange risk
When companies conduct business across borders, they must deal in foreign currencies. Companies must exchange foreign currencies for home currencies when dealing with receivables, and vice versa for payables. This is done at the current exchange rate between the two countries. Foreign exchange risk is the risk that the exchange rate will change unfavorably before the currency is exchanged.
A Forward contract will lock in an exchange rate at which the transaction will occur in the future. An option sets a rate at which the company may choose to exchange currencies. If the current exchange rate is more favorable, then the company will not exercise this option.
Accounting for Derivatives
Guidelines for accounting for financial derivatives are given under IFRS 7. Under this standard, “an entity shall group financial instruments into classes that are appropriate to the nature of the information disclosed and that take into account the characteristics of those financial instruments. An entity shall provide sufficient information to permit reconciliation to the line items presented in the balance sheet”.Inventory items in year 1 and making the payment for them in year 2, after the exchange rate has changed.
|Date||Spot Rate||US $ value||Change||Fwd. Rate||US $ value||FV of contract||Change|
Cash Flow Hedge Example
|12/1/Y1||Inventory||$20,000.00||To record purchase and A/P of 20000C|
|12/31/Y1||Foreign Exchange Loss||$1,000.00||To adjust value for spot of $1.05|
|AOCI||$1,000.00||To record a gain on the forward contract|
|Gain on Forward Contract||$1,000.00|
|Forward Contract||$1,176.36||To record the forward contract as an asset|
|Premium Expense||$266.67||Allocate the fwd contract discount|
|3/1/Y2||Foreign Exchange Loss||$1,400.00||To adjust value for spot of $1.12|
|AOCI||$1,400.00||To record a gain on the forward cont.|
|Gain on Forward Contract||$1,400.00|
|Forward Contract||$423.64||To adjust the fwd. cont. to its FV of $1600|
|Premium Expense||$533.33||To allocate the remaining fwd. cont. discount|
|Foreign Currency||$22,400.00||To record the settlement of the fwd. cont.|
|A/P||$22,400.00||To record the payment of the A/P|
Notice how in year 2 when the payable is paid off, the amount of cash paid is equal to the forward rate of exchange back in year 1. Any change in the forward rate, however, changes the value of the forward contract. In this example, the exchange rate climbed in both years, increasing the value of the forward contract. Since the derivative instruments are required to be recorded at fair value, these adjustments must be made to the forward contract listed on the books. The offsetting account is other comprehensive income. This process allows the gain and loss on the position to be shown in Net income.
The second is a fair value hedge. Again, according to IAS 39 this is “a hedge of the exposure to changes in fair value of a recognized asset or liability or an unrecognized firm commitment, or an identified portion of such an asset, liability or firm commitment, that is attributable to a particular risk and could affect profit or loss”. More simply, this type of hedge would eliminate the fair value risk of assets and liabilities reported on the Balance sheet. Since Accounts receivable and payable are recorded here, a fair value hedge may be used for these items. The following are the journal entries that would be made if the previous example were a fair value hedge.
Fair Value Hedge Example
|12/1/Y1||Inventory||$20,000.00||to record purchase and A/P of 20000C|
|12/31/Y1||Foreign Exchange Loss||$1,000.00||to adjust value for S.R of $1.05|
|Forward Contract||$1,176.36||to record forward contract at fair value|
|Gain on Forward Contract||$1,176.36|
|3/1/Y2||Foreign Exchange Loss||$1,400.00||to adjust value for S.R. of $1.12|
|Forward Contract||$423.64||to adjust the fwd. contract to its FV|
|Gain on Forward Contract||$423.64|
|Foreign Currency||$22,400.00||to record the settlement of the fwd. cont.|
|A/P||$22,400.00||to record the payment of the A/P|
Again, notice that the amounts paid are the same as in the cash flow hedge. The big difference here is that the adjustments are made directly to the assets and not to the other comprehensive income holding account. This is because this type of hedge is more concerned with the fair value of the asset or liability (in this case the account payable) than it is with the profit and loss position of the entity.
Under US GAAP
The US Generally Accepted Accounting Principles also include instruction on accounting for derivatives. For the most part, the rules are similar to those given under IFRS. The standards that include these guidelines are SFAS 133 and 138. SFAS 133, written in 1998, stated that a “recognized asset or liability that may give rise to a foreign currency transaction gain or loss under Statement 52 (such as a foreign-currency-denominated receivable or payable) not be the hedged item in a foreign currency fair value or cash flow hedge”.
Do companies hedge?
Since 2004, the Bank of Canada has carried out a qualitative annual survey to assess the degree of activity in Canadian foreign exchange (FX) hedging. The survey participants comprise banks that are active in Canadian FX markets, including the eleven members of the Canadian Foreign Exchange Committee (CFEC). The 2011 survey was divided into two parts, each separately covering the FX hedging activity of the banks’ corporate and institutional accounts that have CAD hedging requirements. The main findings in the 2011 survey were:
(1) Exporter FX hedging activity continues to be the largest contributor to corporate customer volume and is driven primarily by the actual level of the currency.
(2) Approximately half of the currency exposures are hedged. The majority of institutional accounts have a formal FX hedging policy, while fewer than half of the corporate accounts have any formal policy.
(3) The majority of institutional and corporate hedges are conducted for terms of less than six months.
(4) Given the strength of the CAD, Canadian importers increased both their hedging volumes and the duration of the FX hedges. On the other hand, Canadian exporters delayed hedging their exposures as the CAD appreciated. If they did hedge, only shorter durations were targeted, since exporters expected some future weakness in the CAD.
(5) Due to the strong CAD, Canadian domestic institutional investors increased their foreign investments, but there has been no change in their overall hedging ratio for their foreign assets.
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This article uses material from the Wikipedia article Foreign Exchange Hedge, which is released under the Creative Commons Attribution-Share-Alike License 3.0.