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

tfroarn tshaec tJiaopna fnoers eth ceo Um.pSa. nfiyr.m because it is denominated in local currency. It is a

foreign currency transaction

12-2   Derivatives and Foreign Currency: Concepts and Common Transactions
 

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.

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. 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.

11  Exchange gains and losses occur because of changes in the exchange rates between the transaction date
and the date of settlement. Both exchange gains and exchange losses can occur in either foreign import
activities or foreign export activities. The statement is erroneous.

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. Also hedges of a net investment in a foreign entity are
treated as equity adjustments from translation. Intercompany foreign currency transactions of a long-term
nature are also treated as equity adjustments.

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 
Pur chases $1, 450

Year-end adjAucsctomeunntt  s payabl e ( f $1, 450

c) $ 20
Exchange l oss
Account s payabl e ( f c) $ 20
Settlement date
Account s payabl e ( f c) $1, 470
Cash $1, 460
Exchange gai n 10
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Chapter 12 12-3
 

SOLUTIONS TO EXERCISES 

Solution E12-1 

1  b 
2  c 
3  d 
4  
  a
Solution E12-2 

1  c 
2  a 
3  d 
4  b 

Solution E12-3 

1  b 
2  d 
3  d 

Solution E12-4 

1  The dol l ar has weakened agai nst t he yen because i t now cost s
mor e dol l ar s t o buy one yen.

2 10, 000, 000 yen   $. 0075 = $75, 000

3 Account s payabl e $75, 000

Exchange l oss 1, 000
Cash $76, 000

4  Zi mmer woul d have ent er ed a cont r act t o pur chase yen f or f ut ur e r

ecei pt .
 Thi s woul d assur e t hat Zi mmer had t he yen avai l abl e at t hat dat e t o
pay t hei r obl i gat i on, and woul d have ‘ l ocked i n’ t he amount of US
dol l ar s needed t o sat i sf y t hat obl i gat i on.

Solution E12-5 

December 16, 2011 

I nvent or y $36, 000
Account s payabl e ( eur os) $36, 000
 To r ecor d purchase of mer chandi se f r om Wi ng Cor por at i on f or 30,
000 eur os at $1. 20 spot r at e.

December 31, 2011 

Exchange l oss $ 1, 500
Account s payabl e ( eur os) $ 1, 500
 To adj ust account s payabl e t o Wi ng: ( $1. 25 - $1. 20)   30,
000 eur os.

January 15, 2012 

Account s payabl e ( eur os) $37, 500
Exchange gai n $ 300
Cash 37, 200
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12-  Derivatives and Foreign Currency: Concepts and Common

 To r ecor d payment of 30, 000 eur os at $1. 24 spot r at e i n set t l
ement of account payabl e and t o r ecogni ze gai n.

Solution E12-6 

Adj ust ment i n val ue of account r ecei vabl e f or 2011:

( $. 84 - $. 80)   90, 000 C$ = $3, 600 exchange gai n

Adj ust ment i n val ue of account r ecei vabl e at set t l ement i n

2012: ( $. 83 - $. 84)   90, 000 C$ = $900 exchange l oss

Solution E12-7 

May 1, 2011 
Account s r ecei vabl e ( f c) $333, 333
Sal es $333, 333
 To r ecor d sal e of i nvent or y i t ems t o Royal f or 200, 000
pounds: 200, 000 pounds/ . 6000 pounds ( i ndi r ect quot at i on) .

May 30, 2011 

Cash ( f c) $330, 579
Exchange l oss 2, 754
Account s r ecei vabl e ( f c) $333, 333
 To r ecor d r ecei pt of 200, 000 pounds f r om Royal i n set t l ement
of account s r ecei vabl e: 200, 000 pounds/ . 6050 pounds.

Solution E12-8  [ Based on AI CPA]

1 
Recei vabl e at 10/ 15/ 08 $420, 000
Eur os r ecei ved and sol d f or
U. S. dol l ar s on 11/ 16/ 08 415, 000
For ei gn exchange l oss 2011 5, 000

2  On December 31, 2011 Yumi Cor p. adj ust s i t s account payabl e denomi
nat ed i n eur os f r om $12, 000 ( 10, 000*. $1. 20) t o $12, 400 ( 10, 000  
$1. 24) and
r ecogni zes a l oss of $400 [ 10, 000 LCU   ( $1. 24 - $1. 20) ]

3 
December 31, 2011 not e payabl e $240, 000
 J ul y 1, 2012 not e payabl e 280, 000
2012 exchange l oss $( 40, 000)

4 
Not e r ecei vabl e December 31, 2011 $140,
000 Amount col l ect ed J ul y 1, 2012
( 840, 000 LCU   8) 105, 000
2012 exchange l oss $ 35, 000
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Chapter 12 12-5
 

Solution E12-9 

1 Exchange gai n or l oss i n 2011: Gai n or (

Loss) Account r ecei vabl e December 16 $103, 500
December 31 adj ust ed bal ance
150, 000 C$   $0. 68 102, 000 $( 1, 500)
Acc ount payabl e December 2 $195, 250

December 31 adj ust ed bal ance 187, 000

275, 000 C$   $0. 68
8, 250
Net exchange gai n f or 2011 $ 6, 750

2 Exchange gai n or l oss i n 2012: Gai n or ( Loss)

Account r ecei vabl e adj ust ed 12/ 31 $102,
000 Account r ecei vabl e 1/ 15/ 09
150, 000 C$ x $0. 675 101, 250 $ ( 750)
Account payabl e adj ust ed 12/ 31 $187, 000
Account payabl e 1/ 30/ 09
275, 000 C$ x $0. 685 188, 375 ( 1, 375)
Net exchange l oss f or 2012 $( 2, 125)

Solution E12-10 

1  December 12, 2011 

I nvent or $375,
y Account s payabl e ( yen) 000 $375, 000
Pur chase f r om Toko Company ( 50, 000, 000 yen   $. 00750) .

December 15, 2011 

Account s r ecei vabl e ( pounds) $ 66, 000
Sal es $ 66, 000
Sal e t o Br i t i sh Pr oduct s Company ( 40, 000 pounds    $1. 65) .

2  December 31, 2011 

Exchange l oss $ 5, 000
Account s payabl e ( yen) $ 5, 000
 To adj ust account s payabl e denomi nat ed i n yen f or exchange r at e
change: 50, 000, 000 yen   ( $. 00760 - $. 00750) .
Exchange l oss $ 2, 000
A c c o un t s r e c ei v a bl e ( p o un d s )
 To adj u st a cc o u n t s r ec e i va b l e d e n o mi nat
$ 2 ,0 0 0
ed i n pounds f o r e xc h a nge
r at e change: 40, 000   ( $1. 65 - $1. 60) .
pounds

3 January 11, 2012

Account s payabl e ( yen) $380, 000
Exchange l oss 2, 500
Cash $382, 500
 To r ecor d payment t o Toko Company ( 50, 000, 000 yen   $. 00765) .

January 14, 2012

Cash $ 65, 200
Account s r ecei vabl e ( pounds) $ 64, 000
Exchange gai n 1, 200
 To r ecor d r ecei pt f r om Br i t i sh Pr oduct s Company: 40, 000 pounds
 

$1. 63.
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12-6   Derivatives and Foreign Currency: Concepts and Common Transactions

 
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Chapter 12-
Solution E12-11 
Comment:  The cont r act r ecei vabl e and payabl e ar e bot h r ecor ded i nst
ead of r ecordi ng t he cont r act net because Mar t i n must del i ver t he
eur os t o t he exchange br oker, net set t l ement i s not al l owed.

October 2, 2011 
Cont r act r ecei vabl e $653, 000
Cont r act payabl e ( f c) $653, 000
 To r ecor d cont r act t o sel l 1, 000, 000 eur os t o exchange br oker i n
180 days f or t he f orwar d rat e of $. 6530.

December 31, 2011 

Cont r act payabl e ( f c) $ 12, 000
Exchange gai n $ 12, 000
 To adj ust cont r act payabl e i n euros t o t he 90- day f or war d r at e of
$. 6410.

March 31, 2012 

Cont r act payabl e ( f c) $641,
000 Exchange l oss 14,
000
Cash ( f c) $655, 000
 To r ecor d payment of 1, 000, 000 eur os t o exchange br oker when
spot r at e i s $. 6550.

Cash $653,
Cont r act r ecei vabl e $653, 000
000
 To r ecor d r ecei pt of U. S. dol l ar s f r om exchange br oker i
n set t l ement of account .

SOLUTIONS TO PROBLEMS

Solution P12-1

 TCO woul d r ecei ve $8, 000 f r om XYZ = 100, 000( 2. 48- 2. 40)

Solution P12-2

 Ther e i s a t ypo i n t he pr obl em, Sue' s cos t shoul d be $5. 90

 The expect ed pr of i t f or Sue i s 300, 000 ( 6. 20 - 5. 90) = 90, 000

Economic Economic
Market Price Forward Price Unhedged Gain/(Loss) Income with
per Bushel per Bushel Gain/(Loss) on Forward Hedge

$6.40 $6.20 $150,000 $(60,000) $90,000

$6.30 $6.20 120,000 (30,000) 90,000

$6.20 $6.20 90,000 — 90,000

$6.10 $6.20 60,000 30,000 90,000

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12-8   Derivatives and Foreign Currency: Concepts and Common Transactions

 

$6.00 $6.20 30,000 60,000 90,000

Solution P12-3

 The expect ed pr of i t f or Sue i s 300, 000( 6. 20 - 5. 90 - 0. = 75, 000

05)

Economic
Economic Income (Loss)
Market Price Option Price Unhedged Gain/(Loss) on with Cost of
per Bushel per Bushel Gain/(Loss) Option Option

$6.40 $6.20 $150,000 --- $135,000

$6.30 $6.20 120,000 --- 105,000

$6.20 $6.20 90,000 — 75,000

$6.10 $6.20 60,000 30,000 75,000

$6.00 $6.20 30,000 60,000 75,000

Solution P12-4

1, 2 Per Bal ance Exc hange Gai n

  Books Sheet or ( Loss)
Accounts receivable 
U. S. dol l ar s $28, 500 $28, 500
Swedi sh Kr ona ( 20, 000   $. 66) 11, 800 13, 200 $1, 400
Br i t i sh pounds( 25, 000   $1. 65)
41, 000 41, 250 250
$81, 300 $82, 950 1, 650
Accounts payable 
U. S. dol l ar s $ 6, 850 $ 6, 850
Canadi an dol l ars ( 10, 000   $. 70) 7, 600 7, 000 $ 600
Br i t i sh pounds ( 15, 000   $1. 65) 24, 450 24, 750 ( 300)
$38, 900 $38, 600 300
Net exchange gai n $1, 950

3  Col l ect r ecei vabl es :

Cash $28, 500

Account s r ecei vabl e $28, 500
 To r ecor d col l ect i on of account s r ecei vabl e.
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Chapter 12-
Cash $13, 400
Account s r ecei vabl e ( Kr ona) $13, 200
Exchange gai n 200
 To col l ect 20, 000 Krona at $. 67 spot r at e.

Cash $40, 750

Exchange l oss 500
Account s r ecei vabl e ( pounds) $41, 250
 To col l ect 25, 000 pounds at $1. 63 spot r at
e.
4
Set t l ement of account s payabl e:

Account s payabl e $ 6, 850

Cash $ 6, 850
 To r ecor d payment of account s denomi nat ed i n dol l
ar s.
Account s payabl e ( Canadi an $) $ 7,
000 Exchange l oss 100
Cash $ 7, 100
 To r ecor d payment of account denomi nat ed i n Canadi an dol l ar s at
$. 71 spot r at e.

Account s payabl e ( pounds) $24, 750

Cash $24, 300
Exchange gai n 450
or d payment  To r ec
15, 000 pounds
at $1. 62 spot r at e.

Solution P12-5

1, 2 Bal ance Exchange Gai n

Per Books Sheet or ( Loss)

Accounts receivable
Br i t i sh pounds ( 100, 000    1. 660) $165, 000 $166, 000 $1, 000
Eur os ( 250, 000   $. 670) 165, 000 167, 500 2, 500
Swedi sh kr ona ( 160, 000   $. 105, 600 102, 400 ( 3, 200)
640)
 J apanese yen ( 2, 000, 000   $. 0076) 15, 000 15, 200 200
$450, 600 $451, 100 500

Accounts payable
Canadi an dol l ars ( 150, 000   $. $105, 000 $103, 500 $1, 500
69)
Swedi sh kr ona ( 220, 000   $. 28, 600 29, 700 ( 1, 100)
135)
 J apanese yen ( 4, 500, 000   $. 0076) 33, 300 34, 200 ( 900)
$166, 900 $167, 400 ( 500)

Net exchange gai n $ 0

3  The company woul d need t o ent er i nt o a cont r act t o del i ver 250, 000 eur
os ( sel l t hem) si nce i t woul d be recei vi ng eur os and woul d need t o
conver t
t hem i nt o US dol l ar s.