Hedge Instrument Spot Rate Forward 163461
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Hedge Instrument 11/1//31/13 1/31/14 Spot Rate $1.20 $1.25 $1.30 Forward Rate $1.23 $1.26 $1.30 HedgeCo is interested in purchasing 1,000 units of Product Z from Overseas Inc. HedgeCo is concerned about potential changes in the product's price and adverse movements in the exchange rate before the purchase. Select an appropriate hedging strategy and explain your selection. Use the provided exchange rates to make journal entries, proposing suitable account names. Describe the financial statement effect of each account movement.
Paper For Above instruction
Hedging foreign currency risk is essential for companies engaged in international transactions to mitigate potential financial losses due to unfavorable exchange rate fluctuations. In this scenario, HedgeCo intends to purchase 1,000 units of Product Z from Overseas Inc., and both the product's price and the foreign exchange rate present risks. To address these concerns effectively, choosing the right hedge instrument—either a forward contract or a futures contract—is crucial.
Given the information, a forward contract appears to be the most suitable hedging instrument for HedgeCo. Forward contracts are customized agreements between two parties to buy or sell a specific amount of foreign currency at a predetermined rate on a future date. Their flexibility and tailor-made terms make them ideal when a company has specific transaction needs, such as HedgeCo's purchase scheduled for one month ahead.
Reasoning for selecting a forward hedge:
- Customization: HedgeCo requires a specific amount (equivalent to 1,000 units of Product Z), and forward contracts can be tailored to match this quantity precisely.
- Locking in Rates: The forward rates ($1.23 on 11/1 and $1.26 on 1/1) allow HedgeCo to lock in an exchange rate for the purchase, protecting against unfavorable currency movements.
- Risk Mitigation: By locking in the rate, HedgeCo hedges against the risk of a depreciating USD or an unfavorable move in foreign currency value that could increase the cost of the purchase.
Selection rationalized with the given rates:
- The spot rate is $1.20 on 11/1, increasing to $1.25 by 12/1, and reaching $1.30 on 1/1.
- Forward rates are $1.23 on 11/1 and $1.26 on 1/1, slightly above the spot rate on 11/1 but below the expected future spot on 1/1.
- Locking in the forward rate of $1.26 for the purchase on 1/1 would provide HedgeCo with certainty of the cost in USD—directly, by avoiding the risk of USD weakening or foreign currency appreciating.
Journal Entries:
For the initial entry, assuming HedgeCo enters into a forward contract on 11/1 to purchase foreign currency for the future date (1/1), and the transaction is settled at the forward rate of $1.26, the entries would be:
- At inception of the hedge (11/1):
```plaintext
Dr. Hedge Contract (Asset) $1,260 (1,000 units × $1.26)
Cr. Cash/Bank $1,260
```
- On settlement date (1/1), when paying for the purchase:
```plaintext
Dr. Product Inventory $1,260
Cr. Hedge Contract (Asset) $1,260
```
Alternatively, if recording the hedge as a forward contract liability or asset depends on fair-value measurements, the entries should reflect the fair value of the contract at each reporting date, considering the movement in the exchange rate.
Account names:
- Hedge Contract (asset or liability)
- Cash/Bank
- Product Inventory
Financial statement effects:
- Assets: At inception, an asset (or liability) is recognized equal to the forward contract's value.
- Expenses: When recognizing any realized gain or loss at settlement, that affects net income.
- Equity: Cumulative gains or losses from the hedge are reflected either in other comprehensive income (if designated as a cash flow hedge) or in earnings (if as a fair value hedge).
Using the forward contract shields HedgeCo from exchange rate volatility, providing more predictable costs and protecting profit margins. Proper hedge accounting treatment under standards such as IFRS or US GAAP would involve recognizing the hedge's fair value adjustments in either OCI or earnings depending on the hedge designation.
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References
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