Case 16-6

Case 16-6

A forward exchange contract refers to the organizational agreement to acquire a specified amount of foreign currency at a time. Often, a purchase such as this is conducted at a predetermined rate of exchange (Hodrick, 2014). Moreover, buyers enter these types of contracts to for protection from potential future fluctuations in the rate of exchange of foreign currencies. The main aim of a forward exchange contract is to hedge the position of foreign exchange to minimize or eliminate the risk of loss. Eventually, the move will result in the speculation of the changes and fluctuations in a specified exchange rate to generate profit.

Question 1: Fair Value Hedge

A fair value hedge is a derivative instrument used in balancing out the risk associated with other investments. In this way, the investor can offset the potential losses in the future with regards to the fair value of liabilities or primary assets (Landsman, 2013). Forward exchange contracts (FEC) entered into for fair value hedges are recorded in earnings, where the significance and total value are directly linkable to primary asset holdings. Most importantly, the loss or gain for fair value hedge is highlighted in earnings accumulated during the change period together with the loss or gain on hedged items attributable to similarly hedged risk. 

Forward exchange rate entered into fair value hedges can hardly be accounted for unless the concerned organizations account for the periodic interest rate. Further, the business entities in the hedges must monitor the financial risks through “value-at-risk” models (Barth, 2014). In fact, the organization should always stimulate and calculate the possible rates as derived from the business sales.

Question 2: Foreign Currency Fair Value Hedges

Foreign currency fair value hedges let the corporation focus on business transactions with multinationals. The financial instruments in this type of hedges cannot execute the task of hedging instrument using a foreign currency. Consequently, if a transaction is forecasted, it is well suited to apply these types of hedges.

In a preferred or recognized asset or liability dominated by a foreign currency, an organization establishes the financial gains linked with this hedge type in its earnings (Jin & Jorion, 2012). Even after the corporation recognizes its loss and profit, it lacks an effective system to prevent the exposed positions from fair value hedging. For a foreign currency that has a dominated liability or asset, derivative instruments only must be applied as a hedge.

Question 3: Foreign Currency Cash Flow Hedges

In foreign currency cash flow hedges, the effective portion of derivative loss or gain is reported initially as outside earnings (components of other comprehensive income) but is reclassified into earnings when it is affected by forecasted transactions (Nance et al., 2011). In a debt based on foreign currency, a cash flow hedge is permissible in accounting in order to cover the potential exchange risks.

The financial statements in this type of hedges cannot be used in the evaluation of changes in liabilities or assets to account for risks as recognized in earnings. In addition, the financial results are reported as part of the collective adjustment in the outside income. A reporting such as this is made possible particularly for a derivative designated hedging with exposure to investments outside the home country.

Biblical Application

In 2 Timothy chapter 4 Verse 7-8, the author articulates that the activities undertaken by an individual can help him attain success in the future. By the same token, a firm can lock in a favorable rate of exchange especially in a forward exchange contract.

References

Barth, M. E. (2014). Fair Value Accounting: Evidence from Investment Securities and the Market Valuation of Banks. Accounting Review, 1-25.

Hodrick, R. (2014). The Empirical Evidence on the Efficiency of Forward and Futures Foreign Exchange Markets (Vol. 24). London: Routledge.

Jin, Y., & Jorion, P. (2012). Firm Value and Hedging: Evidence from US Oil and Gas Producers. The Journal of Finance, 61(2), 893-919.

Landsman, W. R. (2013). Is Fair Value Accounting Information Relevant And Reliable? Evidence from Capital Market Research. Accounting and Business Research, 37(sup1), 19-30.

Nance, D. R., Smith, C. W., & Smithson, C. W. (2011). On The Determinants of Corporate Hedging. The Journal of Finance, 48(1), 267-284.