HEDGING EXAMPLE USING A FORWARD CONTRACT EXCHANGE RATE

For Example:

Tennspo Ltd buys goods from a Norwegian supplier on 2 January 2005 for Norwegian krone (NOK) 1 million. The NOK 1 million is payable on 31 March 2005. At 2 January, the exchange rate is NOK 12.50/£.

On 2 January, the company enters into a forward contract to buy NOK 1 million, for delivery on 31 March, at a forward rate of NOK 12.80/£. It therefore knows that, whatever the spot rate on 31 March, it is going to have to pay £78,125 to settle the liability.

The most usual accounting treatment would be for the company to record the purchase at a rate of NOK 12.80/£, i.e. to show the goods as purchased for £78,125. Thus no exchange differences are recorded, either on the purchase or on the forward contract used to hedge it.