Re: Advantages and disadvantages of using forward contracts and options in foreign currency hedging
A forward contract is an agreement between the seller and buyer requiring the delivery of a particular currency at a specified exchange rate at a future date. Under this contract, both parties are obliged to deliver and buy a currency at the specified rate at the maturity of the contract (Hoyle, Schaefer & Doupnik, 2009). The forward exchange rate is determined by looking at the interest rate differentials between the two currencies. It is beneficial to use a forward contract since it locks up the exchange rate. At the date of maturity, both parties must deliver and buy the currencies at the agreed exercise rate. Thus, you will be protected from unfavourable movements in the exchange rate. For instance, a trader does not face the risk of receiving less US Dollars if the exchange rate falls below the exercise rate (Hoyle, Schaefer & Doupnik, 2009). Besides, the rate is fixed hence the trader can determine the amount receivable at the maturity of the contract. This allows the trader to plan, and it makes it easier for the trader to match cash flows.
However, forward contracts have inherent limitations. Firstly, the trader cannot benefit from favourable movements in the exchange rate since the rate is fixed (Madura, 2014). Thus, it is a purely hedging tool and cannot be used for speculative purposes. Furthermore, the parties in a forward contract have a legal obligation to deliver or buy the currencies on the date of maturity. A trader may enter into a forward contract to exchange Japanese Yen for US Dollars when his Japanese debtor pays him. At the maturity of the contract, the trader must deliver Japanese Yen whether the Japanese debtor pays him or not.
Options contract
These are contracts that give the holder the right but an obligation to buy or sell a specified amount of currency at an agreed date at a future date. An option to sell a currency is called a put option while an option to buy is called a put option. Options have a strike or exercise price, which is the rate at which the holder can exercise the option. They also have a nominal cost known as the premium (Madura, 2014). Options are suitable for hedging foreign currency transactions since the holder does not have an obligation to exercise the option. This gives the holder the discretion to exercise the option only when the conditions are favourable. For instance, if the holder was expecting a receivable in foreign currency and purchased a currency option, he does not have to exercise it if the debtor fails to pay him. Besides, options can be used to protect the holder from unfavourable movements and to gain from favourable movements. For instance, if the rate falls below the exercise price, the holder exercises the option since he stands to lose if he converts the currency at the market exchange rate. However, if the rate increases, the holder does not exercise the option and converts the currency at the market rate (Madura, 2014). In that case, the trader only loses the premium or nominal cost of the option.
One disadvantage of options is the potential loss of premium if the option expires out of the money (Madura, 2014). If the exchange rate at the expiry of the option is unfavourable, the holder does not exercise it hence it becomes worthless. Furthermore, it is riskier than forward contracts due to the uncertainty of the amount can receive.
Accounting for the forward contract
On the date of the transaction, December 1, 2009, the value of the contract is recorded to recognise the committed. The value is based on the forward rate on that day ($0.084). on December 31, 2009 (the balance sheet date), the forward contract is revalued based on the forward rate as at that date. The difference between the two values is recognised as a gain or loss.
Value of the forward contract on December 31, 2009 = 1,000,000 × 0.074 = $74,000
$74,000 is receivable on March 1, 2010 hence it should be reported at the presented value.
Present value of the contract = 74,000 × 0.9803 = $72,542.20
Thus, the contract will be reported at $72,542.20 in the liabilities section of the balance sheet.
References
Hoyle, J., Schaefer, T., & Doupnik, T. (2009). Fundamentals of advanced accounting. Boston: McGraw-Hill Irwin.
Madura, J. (2014). International financial management (12th ed.). Mason, Ohio: Thomson/South-Western.
