Download (as for FX options).

CHAPTER
14
USING
DERIVATIVES TO
MANAGE
FOREIGN
CURRENCY
EXPOSURES
Focus of Chapter 14
• 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
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.
To Hedge or Not to Hedge:
That Is the Question
• Hedging is like taking an umbrella with
you in case it rains.
The Technique of Hedging:
The Alternative is Risky
• Not hedging an FX exposure is gambling
that the exchange rate will not change
adversely.
FAS 133 Hedging Categories:
“The Four Amigos”
• Undesignated Hedges
• Fair Value Hedges
• Cash Flow Hedges
• Net Investment Hedges
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: Investments
in foreign subsidiaries (covered in Ch. 18).
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.
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”).
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 gain on the hedged item.
– This is a special accounting
treatment (“hedge accounting”).
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”).
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”).
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.
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.
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.
FX Option Contracts:
Terminology—Calls and Puts
• There are two kinds of options:
–
Call: An option to buy.
–
Put: An option to sell.
FX Option Contracts:
Terminology—Exercise/Strike Prices
• Exercise price means the same as strike
price.
FX Option Contracts:
To Walk Away or Not Walk Away
• The holder can always “walk away.”
• The writer can never walk away.
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.
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 equals the
writer’s LOSS.
• Both parties can break even (but usually
do not).
FX Option Contracts:
The Net Result
• A Zero-Sum Game:
Holder
Writer
NET
$33,000 + $(33,000) = $ -0– Holder’s GAIN = Writer’s LOSS
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. Price
Buy at..... 30 Ex. Price 30
GAIN.... $10
$10
FX Option Contracts: Hopes &
Dreams—The Writer’s Objective
• The option writer hopes that:
The holder “takes a walk” (does not
exercise the option).
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.
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 off of its books over the life of
the contract (the opposite of the accruing
process).
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.
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.
FX Options:
The “Intrinsic Value” Element
• A favorable change in the exchange rate
creates intrinsic value—the option is “in
the money.”
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.
FX Options: Relative Importance
of The Two Elements
• The “Intrinsic value” element is the
elephant.
• The “time value” element is the
elephant’s tail.
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 ).
FX Options:
Split Accounting—Possibilities
Split Accounting Possibilities:
Intrinsic
VALUE the contract:
Value
The same way. . . . . . . . . . . .
A
Differently. . . . . . . . . . . . . . .
A
REPORT the change in value :
The same way . . . . . . . . . . . . X
Differently. . . . . . . . . . . . . . . . X
Time
Value
A
B
X
Y
FX Options: Split Accounting—
Requirements of FAS 133
Intrinsic
Value
Time
Value
Requires the identical
manner of VALUING. . . . . . FV
FV
Requires identical REPORTING
for “undesignated” hedges
In
In
& “fair value” hedges . . . . . Earnings Earnings
Permits different REPORTING
for “cash flow” hedges & or In
In OCI
“net investment” hedges. . . . OCI
Earnings
FX Forwards:
Noncancelable Contracts
• Legal description: A contractual agreement
to exchange currencies at:
3/22/X6
– A specified future date.
$1.37
– A specified exchange rate.
• Substance: A noncancelable purchase
order for a commodity—currency.
• Nature: EXECUTORY—BOTH parties
execute at the settlement (delivery) date.
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.
FX Forwards:
Both Parties Must Execute (Deliver)
• Each party must deliver a currency to
the other party.
• No “walking away” (as for FX options).
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.
FX Forwards:
The Net Result
A Zero-Sum Game:
I. Hedging Party
FX Dealer
NET
$33,000 + $(33,000) = $ -0– Hedger’s GAIN = FX Dealer’s LOSS
II. Hedging Party
FX Dealer
NET
$(22,000) + $22,000 = $ -0– Hedger’s LOSS = FX Dealer’s GAIN
FX Forwards: Whether to Buy
or Sell To Hedge
• “Try to remember...”:
– Method #1— “Buy-Buy” and “SellSell”:
• If buying inventory, buy forward to
hedge.
• If selling inventory, sell forward to
hedge.
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”
FX Forwards: Better to Buy Low
& Sell High Than Vice-Verse
Buying Selling
Forward Forward
Forward rate (the fixed
“locked into”) price:
Buying rate.....................
Selling rate......................
Spot rate at settlement date:
Buying rate.....................
Selling rate......................
Gain (Loss) on FX forward..
$1.75
$1.75
$1.70
$1.70
$ (.05)
$ .05
FX Forwards: Premiums and
Discounts—to Be Accrued
• Premiums and discounts are paid at the tailend 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.
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
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.
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.
FX Forwards:
The “Intrinsic Value” Element
• A change in the exchange rate creates
intrinsic value.
–
Favorable change
= An Asset
–
Unfavorable change = A Liability
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.
FX Forwards: Relative Importance
of The Two Elements
• The “Intrinsic value” element is the
elephant.
• The “time value” element is the
elephant’s tail.
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).
FX Forwards:
Split Accounting—Possibilities
• Split Accounting Possibilities:
Intrinsic Time
Value Value
VALUE the contract:
The same way. . . . . . . . . . . . A
A
Differently. . . . . . . . . . . . . . . A
B
REPORT the change in value :
The same way . . . . . . . . . . . . X
X
Differently. . . . . . . . . . . . . . . . X
Y
FX Forwards: Split Accounting—
Requirements of FAS 133
Intrinsic
Value
Time
Value
Requires the identical
manner of VALUING. . . . . .
FV
FV
Requires identical REPORTING
for “undesignated” hedges
In
In
& “fair value” hedges . . . . . .Earnings Earnings
Permits different REPORTING
for “cash flow” hedges &
In
In OCI or
“net investment” hedges. . . . OCI
Earnings
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.
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).
FX 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.
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).
Derivatives in General:
Types of Underlying Items
• The underlying items from which
derivatives derive their value are:
– Rates French franc .......$.23 (4/1/X6)
– Indexes Dow Jones, Standard & Poors 500
– Financial instruments
– Commodities
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.
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.
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”
Derivatives in General:
Types of Risk
• Three risks in derivatives:
– #2: CREDIT RISK
• Creditors have it.
Derivatives in General:
Types of Risk
• Three risks in derivatives:
– #3: LIQUIDITY RISK (“got CASH?”)
• Debtors have it.
Relationship of Credit Risk
and 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.
End of Chapter 14
• Time to Clear Things Up—Any
Questions?