Chapter 12

Derivatives and Foreign Currency: Concepts and Common Transactions
Answers to Questions
1

Derivative is the name given to a broad range of financial securities. Their common characteristic is that
the derivative contract’s value to the investor is directly related to fluctuations in price, rate, or some other
variable that underlies it. Interest rate, foreign currency exchange rate, commodity prices and stock prices
are common types of prices and rate risks that companies hedge.

2

A Forward is negotiated directly with a counterparty, while a future is a standard contract traded on an
exchange. The exchange traded instrument has less risk of non-performance, and is commonly cheaper to
transact. But standard contracts might not fit all companies’ needs. The forward carries the risk of
counterparty default, but each contract can be tailored to exact needs.

3

An option gives the holder the right to buy or sell the underlying at a set price. The writer of an option has
the obligation to either buy or sell. Options are often traded on exchanges and have low transaction costs.
Because an option is an agreement on a single transaction, they are not helpful in managing the risk of a
stream of future transactions. A swap is an agreement to exchange a series of future cash flows. These are
often negotiated, but there are some standardized exchange-traded swaps.

4

Net settlement means the instrument can be settled in cash for the net value. The parties in a net
settlement do not have to buy or sell physical products and then realize the cash flows. Only one payment
needs to be made, either from the holder or the writer of the instrument.

5

A transaction is measured in a particular currency if its magnitude is expressed in that currency. Assets
and liabilities are denominated in a currency if their amounts are fixed in terms of that currency.

6

Direct quotation: 1.20/1 = $1.20
Indirect quotation: 1/1.20 = .83 euros per dollar

7

Official or fixed rates are set by a government and do not change as a result of changes in world currency
markets. Free or floating exchange rates are those that reflect fluctuating market prices for currency based
on supply and demand factors in world currency markets. The United States changed from fixed to
floating (free) exchange rates in 1971. But the U.S. dollar is sometimes described as a “filthy float”
because the United States has frequently engaged in currency transactions to support or weaken the dollar
against other currencies. Such action is taken for economic reasons, such as to make U.S. goods more
competitive in world markets. Both Japan and Germany have engaged in currency transactions in an
attempt to support the U.S. dollar. In February 1987, the United States and six other industrial nations
(the Group of 7 or G-7) entered the Louvre accord to cooperate on economic and monetary policies in
support of agreed upon exchange rate levels.

8

Spot rates are the exchange rates for immediate delivery of currencies exchanged. The current rate for
foreign currency transactions is the spot rate in effect for immediate settlement of the amounts
denominated in foreign currency at the balance sheet date. Historical rates are the rates that were in effect
on the date that a particular event or transaction occurred. Spot rates could be fixed rates if the currency
was a fixed rate currency as determined by the government issuing the currency.

9

The transaction is a foreign transaction because it involves import activities, but it is not a foreign
currency transaction for the U.S. firm because it is denominated in local currency. It is a foreign currency
transaction for the Japanese company.

10

At the transaction date, assets and liabilities denominated in foreign currency are translated into dollars by
use of the exchange rate in effect at that date, and they are recorded at that amount.

Both exchange gains and exchange losses can occur in either foreign import activities or foreign export activities. 12 Exchange gains and losses on foreign currency transactions are reflected in income in the period in which the exchange rate changes except for hedges of an identifiable foreign currency commitment where deferral is possible if certain requirements are met.450 $1. publishing as Prentice Hall $1.460 10 .470 Pearson Education.12-2 Derivatives and Foreign Currency: Concepts and Common Transactions At the balance sheet date.450 $ 20 $ 20 $1. 11 Exchange gains and losses occur because of changes in the exchange rates between the transaction date and the date of settlement. 13 There will be a $20 exchange loss in the period of purchase and a $10 exchange gain in the period of settlement: Billing date Purchases Accounts payable (fc) Year-end adjustment Exchange loss Accounts payable (fc) Settlement date Accounts payable (fc) Cash Exchange gain $1. Inc. Assets carried at market whose current market price is stated in a foreign currency are adjusted to the equivalent dollar market price at the balance sheet date. cash and amounts owed by or to the enterprise that are denominated in foreign currency are adjusted to reflect the current rate. Intercompany foreign currency transactions of a long-term nature are also treated as equity adjustments. The statement is erroneous. Also hedges of a net investment in a foreign entity are treated as equity adjustments from translation.

000 yen  $. that Zimmer had the yen available at that date to pay and would have ‘locked in’ the amount of US dollars that obligation. January 15. 2012 Accounts payable (euros) $37.000 $76. publishing as Prentice Hall . Solution E12-5 December 16.500 Pearson Education.0075 = $75. Inc.500 To adjust accounts payable to Wing: ($1.$1.500 Accounts payable (euros) $ 1.000 euros.25 .000 euros at $1.000 To record purchase of merchandise from Wing Corporation for 30.000 1.000 entered a contract to purchase yen for future receipt. 2011 Exchange loss $ 1.000 3 Accounts payable Exchange loss Cash 4 Zimmer would have This would assure their obligation.Chapter 12 12-3 SOLUTIONS TO EXERCISES Solution E12-1 1 2 3 4 b c d a Solution E12-2 1 2 3 4 c a d b Solution E12-3 1 2 3 b d d Solution E12-4 1 The dollar has weakened against the yen because it now costs more dollars to buy one yen. 2 10.000 Accounts payable (euros) $36. needed to satisfy $75.20 spot rate. 2011 Inventory $36.20)  30. December 31.000.

$1.600 exchange gain Adjustment in value of account receivable at settlement in 2012: ($.S. 2012 note payable 2012 exchange loss $240.000 $ 35.24) and recognizes a loss of $400 [10.000 LCU  ($1.000 pounds: 200.20) to $12.000 pounds from Royal in settlement of accounts receivable: 200.6050 pounds.6000 pounds (indirect quotation).000 415.20)] 3 December 31. May 30.000 .000  $1.000 On December 31.$. Solution E12-6 Adjustment in value of account receivable for 2011: ($.80)  90.000 (10.84)  90. 2011 note payable July 1. 2011 Accounts receivable (fc) $333.$1.000 pounds/. adjusts its account payable denominated in euros from $12.200 To record payment of 30. 2011 Cash (fc) $330.333 To record receipt of 200.000 C$ = $900 exchange loss Solution E12-7 May 1.000) Note receivable December 31.579 Exchange loss 2.000 5.000 $(40.754 Accounts receivable (fc) $333. 2012 (840.000 4 Pearson Education.000 LCU  8) 2012 exchange loss $140.84 .83 . Inc.333 Sales $333.000 euros at $1. dollars on 11/16/08 Foreign exchange loss 2011 2 $420.24 spot rate in settlement of account payable and to recognize gain.24 .400 (10.333 To record sale of inventory items to Royal for 200.000 pounds/.000 280.$. publishing as Prentice Hall 105. 2011 Amount collected July 1.000 C$ = $3. Solution E12-8 [Based on AICPA] 1 Receivable at 10/15/08 Euros received and sold for U.12-4 Derivatives and Foreign Currency: Concepts and Common Transactions Exchange gain $ 300 Cash 37.000*. 2011 Yumi Corp.

000 yen December 15.000 $ 188. Inc.500) 187.685 Net exchange loss for 2012 Gain or (Loss) $103.000 To adjust accounts receivable denominated in pounds for exchange rate change: 40.000 Accounts payable (yen) $ 5.000.000 yen  ($.000 C$ x $0.000 yen January 14.$.$1.000 C$  $0.000 $195. Exchange loss $ 2.375) $(2.250 $(1.000 Accounts receivable (pounds) $ 2.Chapter 12 12-5 Solution E12-9 1 2 Exchange gain or loss in 2011: Account receivable December 16 December 31 adjusted balance 150.00765). publishing as Prentice Hall $ 64.750 Gain or (Loss) $102. To record payment to Toko Company (50.000 pounds  $1.000  $.000 To adjust accounts payable denominated in yen for exchange rate change: 50.250 $187.200 Pearson Education.675 Account payable adjusted 12/31 Account payable 1/30/09 275.65 .00760 .65).000 Sale to British Products Company (40. 2 December 31. 2012 Accounts payable (yen) Exchange loss Cash $380. 2011 Inventory Accounts payable (yen) $375.500  $.500 102.000 C$ x $0.250 $ 6.000 8.500 $382.375 (750) (1.000.000 $ 66.000.000 C$  $0.00750).00750).000 $375. 2011 Exchange loss $ 5.000 2.000 pounds  ($1.000 101. 2011 Accounts receivable (pounds) Sales $ 66. 2012 Cash Accounts receivable (pounds) $ 65.125) Solution E12-10 1 December 12.60).000 . 3 January 11.68 Account payable December 2 December 31 adjusted balance 275. Purchase from Toko Company (50.68 Net exchange gain for 2011 Exchange gain or loss in 2012: Account receivable adjusted 12/31 Account receivable 1/15/09 150.

12-6 Derivatives and Foreign Currency: Concepts and Common Transactions Exchange gain 1. publishing as Prentice Hall .63.000 pounds  $1. Inc.200 To record receipt from British Products Company: 40. Pearson Education.

000 90. December 31.000(2.000 30.90) = 90.48-2.20 .20 $6.000 (30.000.000 Contract receivable $653.000 To record payment of 1. Cash $653. Sue's cost should be $5.000 $6.Chapter 12 12-7 Solution E12-11 Comment: The contract receivable and payable are both recorded instead of recording the contract net because Martin must deliver the euros to the exchange broker.000 60. March 31.20 Economic Gain/ (Loss) on Forward Economic Income with Hedge $(60.30 $6. publishing as Prentice Hall .20 $150.000 90.6410.000 To record contract to sell 1.40 $6.000) $90.5.000 60.000 Exchange gain $ 12.000 90.000 30.00 $6.000 (6. 2012 Contract payable (fc) $641.000 euros to exchange broker in 180 days for the forward rate of $.000 Market Price per Bushel Forward Price per Bushel Unhedged Gain/(Loss) $6.40) Solution P12-2 There is a typo in the problem.S.000.000 To adjust contract payable in euros to the 90-day forward rate of $.000 Exchange loss 14.000 — 90.90 The expected profit for Sue is 300.000 from XYZ = 100.6550. 2011 Contract receivable $653.20 $6.000 Pearson Education. October 2. net settlement is not allowed.20 120.000) 90. dollars from exchange broker in settlement of account. SOLUTIONS TO PROBLEMS Solution P12-1 TCO would receive $8.10 $6. 2011 Contract payable (fc) $ 12.6530.000 Cash (fc) $655.000 euros to exchange broker when spot rate is $. Inc.000 $6.000 Contract payable (fc) $653.20 $6.000 To record receipt of U.

20 — 75.000  $1.000 24. dollars Swedish Krona (20.950 $1.20 $6.70) British pounds (15.000 pounds at $1. dollars Canadian dollars (10.500 13.450 $38.000 $81.000 90.500 $13.20 $150.000  $.05) = 75.000 30.000 Krona at $. Pearson Education.250 .000 Solution P12-4 1.000 $6. Inc.000 $6.65) Accounts payable U.600 Net exchange gain 3 $ 600 (300) 300 $1.950 Collect receivables: Cash $28.65) Per Books Balance Sheet Exchange Gain or (Loss) $28.400 Accounts receivable (Krona) Exchange gain To collect 20.10 $6.500 11.200 200 $41.30 $6.750 $38.40 $6.650 $ 6.900 $ 6.200 41.400 250 1.600 24.90 .000  $1.000 --- $135.20 60. Cash $28.000 $6.67 spot rate.850 7.00 $6.000  $.000 75.20 120.66) British pounds(25.20 30.5.000 60.800 41.750 Exchange loss 500 Accounts receivable (pounds) To collect 25.000(6.63 spot rate.0.S.000 --- 105. publishing as Prentice Hall $13.12-8 Derivatives and Foreign Currency: Concepts and Common Transactions Solution P12-3 The expected profit for Sue is 300.000 Unhedged Gain/(Loss) Economic Gain/ (Loss) on Option Economic Income (Loss) with Cost of Option Market Price per Bushel Option Price per Bushel $6.850 7.000 $6. 2 Accounts receivable U.S.250 $82.300 $28. Cash $40.20 .000 75.500 Accounts receivable To record collection of accounts receivable.

000 167.100 $1. Inc.69) Swedish krona (220. Pearson Education.0076) Accounts payable Canadian dollars(150.500 102. publishing as Prentice Hall .000  $.000 28.200 $167.71 spot rate.850 To record payment of accounts denominated in dollars. Solution P12-5 1.750 Cash $24.200) 200 500 $105.700 34.640) Japanese yen (2. 2 Accounts receivable British pounds (100.000 2.600 $166.500 29.300 $166. Accounts payable (Canadian $) $ 7.500 (1.200 $451.400 $1.900 $103.850 Cash $ 6.000 euros (sell them) since it would be receiving euros and would need to convert them into US dollars.100) (900) (500) Net exchange gain 3 $ 0 The company would need to enter into a contract to deliver 250.000 $450.100 To record payment of account denominated in Canadian dollars at $.400 15.000 165.670) Swedish krona (160.0076) Per Books Balance Sheet Exchange Gain or (Loss) $165.000  $.000  $.500 (3.600 15.000.600 33.000 105.500.660) Euros (250.135) Japanese yen (4.62 spot rate.000  $.000  $.000 Exchange loss 100 Cash $ 7.300 Exchange gain 450 To record payment of 15. Accounts payable (pounds) $24.000  1.000  $.Chapter 12 4 12-9 Settlement of accounts payable: Accounts payable $ 6.000 pounds at $1.