A foreign exchange hedge transfers the foreign exchange risk from the trading or investing company to a business that carries the risk, such as FX Exchange Rate bank. There is cost to the company for setting up a hedge. By setting up a hedge, the company also forgoes any profit if the movement in the exchange rate would be favourable to it.
When companies conduct business across borders, they must deal in foreign currencies. Companies must exchange foreign currencies for home currencies when dealing with receivables, and vice versa for payables. This is done at the current exchange rate between the two countries. Foreign exchange risk is the risk that the exchange rate will change unfavorably before payment is made or received in the currency .
A hedge is a type of derivative, or a financial instrument, that derives its value from an underlying asset. Hedging is a way for a company to minimize or eliminate foreign exchange risk. A forward contract will lock in an exchange rate today at which the currency transaction will occur at the future date. An option sets an exchange rate at which the company may choose to exchange currencies. If the current exchange rate is more favorable, then the company will not exercise this option.
The main difference between the hedge methods is who derives the benefit of a favourable movement in the exchange rate. With a forward contract the other party derives the benefit, while with an option the company retains the benefit by choosing not to exercise the option if the exchange rate moves in its favour. Guidelines for accounting for financial derivatives are given under IFRS 7. The International Accounting Standards IAS 32 and 39 help to give further direction for the proper accounting of derivative financial instruments.
Below is an example of a cash flow hedge for a company purchasing Inventory items in year 1 and making the payment for them in year 2, after the exchange rate has changed. To record a gain on the forward cont. To record the settlement of the fwd. Notice how in year 2 when the payable is paid off, the amount of cash paid is equal to the forward rate of exchange back in year 1. Any change in the forward rate, however, changes the value of the forward contract. In this example, the exchange rate climbed in both years, increasing the value of the forward contract.
Since the derivative instruments are required to be recorded at fair value, these adjustments must be made to the forward contract listed on the books. The second is a fair value hedge. Again, notice that the amounts paid are the same as in the cash flow hedge. The big difference here is that the adjustments are made directly to the assets and not to the other comprehensive income holding account. The US Generally Accepted Accounting Principles also include instruction on accounting for derivatives. For the most part, the rules are similar to those given under IFRS. The standards that include these guidelines are SFAS 133 and 138.
Banks have increased their attention on regulatory issues. Volatility was the main reason for hedging. Institutional customer volume accounted for the majority of hedging activity. There was high marginal use of derivatives in hedging. Summary of the 2013 Survey on Canadian Foreign Exchange Hedging”.