Question
Fair Value Hedges of Foreign Currency Denominated Assets and Liabilities For fair value hedges, the following is required: a. The hedged asset or liability is
Fair Value Hedges of Foreign Currency Denominated Assets and Liabilities
For fair value hedges, the following is required:
a. The hedged asset or liability is adjusted to fair value based on changes in the spot exchange rate, and a foreign exchange gain or loss is recognized in net income.
b. The derivative hedging instrument is adjusted to fair value (resulting in an asset or liability reported on the balance sheet), with the counterpart recognized as a gain or loss in net income.
c. The net foreign exchange gain or loss is adjusted to reflect amortization of the original discount or premium on the forward contract (if a forward contract is being used as the hedging instrument) OR the change in the time value of the FX option (if an FX option is being used).
For cash flow hedges, the following is required:
a. The hedged asset or liability is adjusted to fair value based on changes in the spot exchange rate, and a foreign exchange gain or loss is recognized in net income.
b. The derivative hedging instrument is adjusted to fair value (resulting in an asset or liability reported on the balance sheet), with the counterpart recognized as a gain or loss in Other Comprehensive Income (OCI).
c. An amount equal to the FX gain or loss is transferred to other comprehensive income from net income (the net effect is to offset any gain or loss on the hedged asset or liability)
d. An additional FX loss is recognized in net income (with counterpart in OCI) to reflect the current periods amortization of the original discount or premium on the forward contract (if a forward contract was used to hedge) OR the change in the time value of the option (if an option was used to hedge).
Example: On 12/1/21, we sell goods on account with a 1,000,000 euro receivable in three months. To hedge the transaction, we also enter into a forward contract with a bank to sell euros for dollars in three months. Exchange rates are as follows:
Date | Spot rate | Forward rate to Mar 1 |
12/1/21 | $0.92 | $0.905 |
12/31/21 | 0.93 | 0.916 |
3/1/22 | 0.90 | 0.900 |
Assume the firm chooses a fair value hedge.
a) Entry on 12/1/21:?
b) Entries on 12/31/21?
c) Entries on 3/1/22:?
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