Draft A Memo To A Client Comparing The Advantages And Disadv

Draft a memo to a client comparing the advantages and disadvantages of using forward contracts and options to hedge foreign exchange risk.

Submit your responses in MS Word as one document. Label each section clearly. If you choose to use an Excel spreadsheet for question 2, please copy and paste your spreadsheet into your Word document. For written answers, please make sure your responses are well written, conform to CSU-Global guidelines for APA formatting, and have proper citations, if needed.

On December 1, 2009, a U.S.-based company entered into a three-month forward contract to purchase 1 million Mexican pesos on March 1, 2010. The following are the purchase rates for US dollar per peso:

• December 1, 2009: Spot Rate $0.088; Forward Rate (March 2010): $0.084
• December 31, 2009: Spot Rate $0.080; Forward Rate (March 2010): $0.074
• March 1, 2010: Spot Rate $0.076

The company’s borrowing rate is 12 percent. The present value factor for two months at an annual interest rate of 12 percent (1 percent per month) is 0.9803.

How will the U.S. company report the forward contract on its December 31, 2009, balance sheet?

Paper For Above instruction

The memorandum aims to inform the client about the strategic and financial implications of using forward contracts versus options to hedge against foreign exchange risk, with specific focus on the case of the U.S.-based company’s transaction involving Mexican pesos.

Introduction

Foreign exchange risk poses a significant challenge for multinational corporations engaging in cross-border transactions. Effective hedging strategies are essential to mitigate potential adverse impacts on financial performance. Two prevalent instruments used for hedging are forward contracts and options. While both serve the purpose of locking in exchange rates, they differ in structure, cost, flexibility, and risk management attributes. This memo evaluates the advantages and disadvantages of these hedging tools, with practical implications illustrated through a recent transaction involving Mexican pesos, and addresses regulatory reporting considerations.

Forward Contracts: Definition, Advantages, and Disadvantages

A forward contract is a customized agreement between two parties to buy or sell a currency at a predetermined rate on a specified future date. It offers certainty regarding transaction costs, making it attractive for firms seeking to stabilize cash flows and budget expectations. The primary advantage of forward contracts is their simplicity and cost-effectiveness, as they typically involve no upfront premium—instead, the profit or loss depends on the difference between the contract rate and the spot rate at settlement (Eiteman, Stonehill, & Moffett, 2019).

However, forward contracts also have disadvantages. Being customized and over-the-counter (OTC) instruments, they carry counterparty risk—the possibility that one party may default on the agreement (Madura, 2018). Additionally, firms forgo the potential benefit of favorable currency movements since they are obligated to transact at the contracted rate, regardless of how the spot rate evolves favorably (Shapiro, 2021).

Options: Definition, Advantages, and Disadvantages

An option grants the right, but not the obligation, to buy (call option) or sell (put option) a currency at a specified strike price before or at expiry. This financial instrument involves a premium paid upfront, representing the option’s cost. The main advantage of options lies in their flexibility and asymmetric risk profile—firms can benefit from favorable movements in exchange rates while limiting losses to the premium paid (Calloway, 2020).

Despite their flexibility, options are generally more expensive than forward contracts due to the premium. They also require ongoing management and understanding of option mechanics and pricing models, which can be complex. Moreover, if the spot rate moves unfavorably, the firm can let the option expire and transact at the current market rate—potentially incurring higher costs than a forward transaction (Eiteman et al., 2019).

Case Analysis: Implication of the December 31, 2009, Exchange Rates and Reporting

In the specified scenario, by December 31, 2009, the spot rate has decreased from the initial rate of $0.088 to $0.080. The company entered into a forward contract with a rate of $0.084. According to Generally Accepted Accounting Principles (GAAP), the company must report the fair value of its foreign currency hedging instruments at each reporting date (FASB, 2010).

Given the decline in the spot rate, the forward contract’s fair value would be adjusted to reflect its current market value, which is derived from the difference between the forward rate and the market’s prevailing forward rate for settlement on March 1, 2010. The reduction in the spot rate and the forward rate indicates that the company could face a loss if the contract is settled at the forward rate of $0.084, given that it could purchase pesos at a lower spot rate ($0.080) on December 31.

Consequently, on the December 31, 2009, balance sheet, the company must recognize a liability for the decrease in the fair value of the forward contract, calculated based on the difference between the contracted forward rate and the current fair value. The valuation adjustment involves using the present value factor of 0.9803 at a borrowing rate of 12 percent over two months. This ensures that financial statements accurately reflect the economic reality and adhere to hedge accounting standards.

Conclusion

In conclusion, both forward contracts and options are viable tools for hedging foreign exchange risk, each serving different strategic objectives. Forward contracts offer cost-effective and straightforward certainty but lack flexibility and carry counterparty risk. Options provide flexibility and limited downside risk at a higher cost, suitable for firms seeking to benefit from favorable rate movements. The choice between these instruments depends on the firm's risk appetite, cost considerations, and market outlook.

For the specific transaction, proper accounting treatment necessitates detailed valuation and disclosure of the forward contract’s fair value as of December 31, 2009, to ensure compliance with financial reporting standards and provide transparent information to stakeholders. Strategic use of these instruments should align with the firm's overall risk management policy to optimize financial stability and operational performance.

References

• Calloway, W. (2020). Financial Management: Principles and Applications. Routledge.
• Eiteman, D. K., Stonehill, A. I., & Moffett, M. H. (2019). Multinational Business Finance (13th ed.). Pearson.
• FASB. (2010). Accounting Standards Codification (ASC) Topic 815: Derivatives and Hedging. Financial Accounting Standards Board.
• Madura, J. (2018). International Financial Management (13th ed.). Cengage Learning.
• Shapiro, A. C. (2021). Multinational Financial Management (12th ed.). Wiley.