Forex Markets | A Crackdown On Currency Hedging
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A foreign exchange hedge also called a FOREX hedge is a method used by companies to eliminate or " hedge " their foreign exchange risk resulting from transactions in foreign currencies see foreign exchange derivative. This is done using either the cash flow hedge or the fair value method. A foreign exchange hedge transfers the foreign exchange risk from the trading or investing company to a business that carries the risk, such as a bank.
There is cost to the company for setting up a hedge. By setting up a hedge, the company also forgoes any profit if the movement in the exchange rate would be favourable to it. 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 payment is made or received in the currency. For example, if hedging in the foreign exchange market forex market United States company doing business in Japan is compensated in yen, that company has risk associated with fluctuations in the value of the yen versus the United States dollar. A hedge is a type of derivativeor a financial instrumentthat derives its value from an underlying asset.
Hedging is a way for a company to minimize or eliminate foreign exchange risk. Two common hedges are forward contracts and options. A forward contract will lock in an exchange rate today at which the currency transaction will occur at the future date. An option sets an exchange 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. The main difference between the hedge methods is who derives the benefit of a favourable movement in the exchange rate.
With a forward contract the other party derives the benefit, while with an option the company retains the benefit by choosing not to exercise the option if the exchange rate moves in its favour. Guidelines for accounting for financial derivatives are given under IFRS 7. This seems fairly straightforward, but IASB has issued two standards to help further explain this procedure. The International Accounting Standards IAS 32 and 39 help to give further direction for the proper accounting of derivative financial instruments.
The entity required to pay the contract holds a liability, while the entity receiving the contract payment holds an asset. These would be recorded under the appropriate headings on the balance sheet of the respective companies. IAS 39 gives further instruction, stating that the financial derivatives be recorded at fair value on the balance sheet. IAS 39 defines two major types of hedges. The first is a cash flow hedge, defined as: Below is an example of a cash flow hedge for a company purchasing Inventory items in year 1 and making the payment for them in year 2, after the exchange rate hedging in the foreign exchange market forex market changed.
Notice how in year 2 when the payable is paid off, the amount hedging in the foreign exchange market forex market 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. 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. Again, notice that the amounts paid are hedging in the foreign exchange market forex market 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 hedging in the foreign exchange market forex market 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 hedging in the foreign exchange market forex market than it is with the profit and loss position of the entity. For the most part, the rules are similar to those given under IFRS. The standards that include these guidelines are SFAS and The use of a hedge would cause them to be revalued as such. Remember that the value of the hedge is derived from the value of the underlying asset.
The amount recorded at payment or reception would differ from the value of the derivative recorded under SFAS As illustrated above in the example, this difference between the hedge value and the asset or liability value can be effectively accounted for by using either a cash flow or a fair value hedge. Citing the reasons given previously, SFAS required the recording of derivative assets at fair value based on the prevailing spot rate.