Monday, December 7, 2009

HEDGING NON- TRADING TRANSACTIONS

SSAP20 allows a company that has a trading transaction covered by a related or matching forward contract to translate the trading transaction at the rate implied by the contract .But companies often use forward currency contracts to hedge the exchange risk inherent in non-trading transactions involving foreign currencies. For example, a company may use a forward contract to fix, in sterling terms, the amount it will have to pay for a fixed asset, or the amount it will receive when a loan is repaid.

And companies do not only use forward contracts to hedge exchange risks – they may use exchange-traded currency futures, or currency options or currency swaps.
SSAP20 does not spell out how companies should account for the transaction, and the associated derivative contract, in such circumstances. But in practice many companies interpret ‘trading transaction’ broadly. Where a forward contract has been taken out specifically to hedge a particular foreign currency asset or liability, it is usual for a company to account for that asset or liability at the rate implied by the forward contract.

For Example: Uzubay plc makes a loan to a subsidiary of €2 million, repayable in 12 months. At the same time, it contracts with its bank to sell €2 million for £1,230,000 in 12 months’ time. Thus the company has no real exposure to euro/sterling exchange rates: whatever the exchange rate does, it will receive £1,230,000 when the loan matures. The company is likely to translate the loan at the rate implied by the forward contract, showing it at £1,230,000 throughout, and not recognizing any exchange differences.

In the above example, the company might use a euro/sterling currency swap to hedge the loan instead of a currency forward. Most companies will, in such circumstances, use the rate implied by the currency swap to account for the loan, in a precisely similar way.

Currency options – although they can be used as a hedge – are different. It would be misleading to translate an asset or liability at the rate implied by a currency option (the strike price), because the company is under no obligation to exercise the option. The currency option and any related transaction, asset or liability will be accounted for separately

Friday, December 4, 2009

HEDGING EXAMPLE USING SEPARATE EXCHANGE RATES

For Example:

The facts are as in previous example, except that the company accounts for the purchase and the forward currency contract separately. The exchange rate at 31 March is NOK 13.00/£.

The NOK 1 million debts that the company incurs on 2 January is valued at £80,000 on that date, but it only costs the company £78,125 to settle it on 31 March. An exchange gain of £1,875 therefore arises.

The company has contracted to buy NOK 1 million for £78,125 on 31 March, but at that date the currency is only worth £76,923 at spot rates. A loss of £1,202 arises on the forward contract.

Thursday, December 3, 2009

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.

Wednesday, December 2, 2009

HEDGING WITH A FORWARD CONTRACT

Transactions covered by a matching forward contract

If a trading transaction is covered by a forward foreign exchange contract so that the company knows how much in sterling terms it will pay or receive, SSAP permits the company to translate the transaction at the exchange rate implied in the contract.

While SSAP20 permits this treatment, it does not require it, and the company could record the purchase and the forward contract as two separate transactions.

While either treatment accords with UK GAAP, the first treatment is more common in practice. Assuming that the company entered into the currency contract specifically to hedge the purchase, the first treatment better reflects the underlying economic reality – the company was never really exposed to fluctuations in exchange rates.