Chapter 12

Derivatives and
Foreign
Currency:
Concepts and
Common
Transactions

Derivatives and Foreign Currency

Concepts and Common Transactions:
Objectives
1.
2.
3.

4.
5.

Understand the definition of a derivative and the types of

risks that derivatives can manage.
Understand the structure, benefits and costs of options,
futures, forward contracts, and swaps.
Understand key concepts related to foreign currency
exchange rates, such as indirect and direct quotes; floating,
fixed, and multiple exchange rates; and spot, current, and
historical exchange rates.
Explain the difference between receivable or payable
measurement and denomination.
Record foreign currency-denominated sales/receivables and
purchases/payables at the initial transaction date, year-end,
and the receivable or payable settlement date.

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Derivatives and Foreign Currency:

Concepts and Common Transactions

1: DERIVATIVES

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Derivative (definition)
The name given to a broad range of financial securities.
The derivative's value to the investor is directly related
to fluctuations in price, rate or some other variable that
underlies it.
A derivative can be used to offset (hedge) the
potential fluctuation in

Interest rates
Commodity prices
Foreign currency exchange rates
Stock prices

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Using Derivatives as Hedges

A hedge can
Shift risk of fluctuations in sales prices,
costs, interest rates, or currency
exchange rates
Help manage costs
Reduce risks to improve financial position
Produce tax benefits
Help avoid bankruptcy

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Derivatives and Foreign Currency:

Concepts and Common Transactions

2: TYPES OF DERIVATIVES

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Derivatives
The four basic types of derivatives are:

Forward Contracts
Futures Contracts
Options
Swaps

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Forward Contracts
Forward Contracts are
Negotiated contracts between two parties
For the delivery or purchase of
A commodity or
A foreign currency

At an agreed upon price, quantity, and delivery

date.

Settlement of the forward contract may be

Physical delivery of the good, or
Net settlement

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Futures Contracts
Futures contracts are a specific type of
forward contract
Characteristics are standardized
Characteristics are set by futures exchanges
(Rather than by the contracting parties) so
performance risk is eliminated
Exchange guarantees performance

Settlement may also be made by entering

another futures contract in the opposite
direction.
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12-9

Options
Options are right (but not the obligation) to
either
Call (buy), or
Put (sell)
With options, only one party is obligated to
perform depending on the election of the
other party to exercise their option.

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Swaps
Swaps are contracts to exchange an ongoing
stream of cash flows, commonly swapping
interest rates.
Swap variable- for fixed-rate debt, or
Swap fixed- for variable-rate debt
Swaps are commonly negotiated on an
individual basis like forward contracts, but
may be standardized and exchange-traded
like futures.
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Example: Forward Contract

Sam decides to sell future production by entering into
a forward contract with Irene for delivery of 10,000
items in one year at a price of $10 per item. Thus,
Sam has determined their selling price regardless of
the market, and Irene has locked in her purchase
price.
Sam risks loss of potential revenue if the market
price for the items increases in the next year. Irene
risks loss of potential savings if the market price for
the items decreases in the next year.

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Forward Contract Impact

If Sams fixed costs are $50,000, and the variable
cost is $3 per unit, Sam will lock in profit of $20,000
($100,000 revenue less $50,000 fixed costs less
$30,000 variable costs).
If the market price for the item increases, Sam can
sell at the higher market price and settle with Irene
by paying her the difference, or simply sell the items
to Irene at the contracted price. Either way, Sam has
profit of $20,000.

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Derivatives and Foreign Currency:

Concepts and Common Transactions

3: FOREIGN CURRENCY
EXCHANGE

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12-14

Measurement and
Denomination
Measured in a currency
Recorded in the financial records in that
currency
Denominated in a currency
Requires settlement (payment or
receipt) in that currency
For U.S. firms
U.S. dollar is the measurement currency
Payables and receivables may be
denominated in U.S. dollars or other
currencies
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Quoting Exchange Rates

Direct quotation (U.S. dollars per one foreign
currency unit)
$1.60 (U.S. dollars) for 1 (British pound)
Indirect quotation (foreign currency units per
one U.S. dollar)
0.625 (British pounds) for $1 (U.S.
dollar)
Direct and indirect quotes are reciprocals
1 / $1.60 = 0.625
$1 / 0.625 = $1.60
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Establishing Exchange Rates

Exchange rates may be fixed by a governmental
unit or may be allowed to fluctuate (float) with
changes in the currency markets.
Official (fixed) exchange rates are set by a
government and do not fluctuate with the
changes in the world currency markets.
Free (floating) exchange rates reflect the
fluctuating market prices for a currency based
on supply and demand and other factors in
the world currency markets.

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Various Exchange Rates

Spot rate
Exchange rate for immediate delivery
Current rate
Exchange rate at balance sheet date,
or
Exchange rate at the time a transaction
takes place
Historical rate
Exchange rate that existed when a
specific transaction or event occurred

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Derivatives and Foreign Currency:

Concepts and Common Transactions

4: SALES AND PURCHASES

DENOMINATED IN FOREIGN
CURRENCY

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Currency Denomination
A companys functional currency is the
currency in which they transact the majority
of their business.
A foreign currency transaction is any
transaction that is measured and settled
(denominated) in a currency other than the
companys functional currency.

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Foreign Exchange Risk

Foreign Exchange Risk is the risk that the
functional currency and the currency used in
the transaction will change in value compared
to each other, and the company will lose
money as a result.

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Derivatives and Foreign Currency:

Concepts and Common Transactions

5: RECORDING FOREIGN
CURRENCY TRANSACTIONS

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Foreign Currency Purchases

Purchases on account denominated in a foreign
currency are subject to risk.
Changes in the foreign exchange rate may
Increase Accounts Payable, resulting in an
exchange loss, or
Decrease Accounts Payable, resulting in
an exchange gain
Foreign currency Accounts Payable is adjusted
to fair value each period until paid.

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Foreign Currency Sales

Sales on account denominated in a foreign
currency are subject to risk.
Changes in the foreign exchange rate may

Increase Accounts Receivable, resulting in an

exchange gain, or
Decrease Accounts Receivable, resulting in an
exchange loss

Foreign currency Accounts Receivable is

adjusted to fair value each period until
collected.

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Example: Purchase on Account

On 11/1, Sam purchases inventory for 500
euros on account. Sam pays for these goods
on 1/30. Pertinent rates:

Date

Spot rate

Acct Pay

11/1

$1.35

$675

12/31

$1.36

$680

$(5)

1/30

$1.38

$690

$(10)

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Gain (Loss)

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Purchase on Account - Entries

11/1 Inventory

Adjust
payable to
current
rate.
Convert
dollars to
euros so
proper funds
are available
for payment.

675

Account Payable(euros)
12/31 Exchange loss

675
5

Account Payable(euros)
1/30 Cash (euros)

5
690

Cash ($)
1/30

Account Payable (euros)

Exchange loss

Cash in
(euros)
Make payment
euros,
recognizing
additional loss.

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690
680
10
690

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Example: Sale on Account

On 11/1, Sam sells goods for 500 euros on account.
The customer pays on 1/30 and cash is converted
on that date. Pertinent rates:

Date

Spot rate

Acct Rec

11/1

$1.35

$675

12/31

$1.36

$680

$5

1/30

$1.38

$690

$10

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Gain (Loss)

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Sale on Account - Entries

11/1 Accounts receivable (euros)

Adjust
receivable
to current
rate.

Sales
12/31 Accounts receivable (euros)

675
5

Exchange gain
1/30 Cash (euros)

Collect
from
customer,
recognizing
additional
gain

675

5
690

Acct receivable (euros)

680

Exchange gain
1/30 Cash ($)
Cash (euros)

10
690
690

Convert funds.

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