Question

Albert, CEO of XYZ, Inc., desires to expand the company’s sales through exports to three (3) foreign subsidiaries. Albert knows that the target subsidiaries are located in countries that require transactions to be denominated in the local currencies. Albert has researched foreign currency risk and knows that there is accounting exposure in accounting statements, operating exposure in future cash flows, and transaction exposure in outstanding obligations. Albert does not understand how these risks apply to XYZ, Inc. under his proposal or if there are any mitigating risk strategies available. Albert requests you, the head of the Risk Management division, to prepare a report that he can present to the Board of Directors on the potential foreign currency risk if XYZ, Inc. expands sales into these markets. XYZ, Inc.’s reporting currency is the U.S. dollar and the subsidiaries would purchase the merchandise as inventory items.

Note: You may create and / or make all necessary assumptions needed for the completion of this assignment.

Write a three to five (3-5) page paper in which you:

1. Specify accounting exposure, operating exposure, and transaction exposure. Determine the main financial statement effects of each type of exposure if XYZ, Inc. expands as proposed.
2. Determine two (2) types of hedges regarding foreign exchange risk, in general, and recommend the most advantageous risk mitigation strategy for XYZ, Inc. Provide support for your rationale. Note: Refer to Chapter 9 of the textbook for more information on corporate strategies regarding hedging foreign exchange risk.
3. Determine the main accounting assumptions underlying each currently used method (e.g., current rate method and temporal method). Determine the fundamental differences in balance sheet exposure from the application of each method.
4. Suggest the translation method that XYZ, Inc. should use in order to minimize balance sheet exposure. Provide support for your choice.
5. Compare the U.S. GAAP approach to the IFRS approach of translating foreign currency financial statements. Determine the main similarities and differences between the two (2) methods of translation. Assuming one (1) of the subsidiaries of XYZ, Inc. is located in a highly inflationary country, determine the appropriate translation method under FASB and provide the theoretical justification for your response.    
6. Use at least two (2) quality academic resources in this assignment. Note: Wikipedia and similar websites do not qualify as academic resources.

Answer 1

Definition: The Foreign Exchange Transactions refers to the sale and purchase of foreign currencies. Simply, the foreign exchange transaction is an agreement of exchange of currencies of one country for another at an agreed exchange rate on a definite date.

1.         Spot Transaction: The spot transaction is when the buyer and seller of different currencies settle their payments within the two days of the deal. It is the fastest way to exchange the currencies. Here, the currencies are exchanged over a two-day period, which means no contract is signed between the countries. The exchange rate at which the currencies are exchanged is called the Spot Exchange Rate. This rate is often the prevailing exchange rate. The market in which the spot sale and purchase of currencies is facilitated is called as a Spot Market.

2.         Forward Transaction: A forward transaction is a future transaction where the buyer and seller enter into an agreement of sale and purchase of currency after 90 days of the deal at a fixed exchange rate on a definite date in the future. The rate at which the currency is exchanged is called a Forward Exchange Rate. The market in which the deals for the sale and purchase of currency at some future date is made is called a Forward Market.

3.         Future Transaction: The future transactions are also the forward transactions and deals with the contracts in the same manner as that of normal forward transactions. But however, the transactions made in a future contract differs from the transaction made in the forward contract on the following grounds:

•           The forward contracts can be customized on the client’s request, while the future contracts are standardized such as the features, date, and the size of the contracts is standardized.

•           The future contracts can only be traded on the organized exchanges, while the forward contracts can be traded anywhere depending on the client’s convenience.

•           No margin is required in case of the forward contracts, while the margins are required of all the participants and an initial margin is kept as collateral so as to establish the future position.

1.         Swap Transactions: The Swap Transactions involve a simultaneous borrowing and lending of two different currencies between two investors. Here one investor borrows the currency and lends another currency to the second investor. The obligation to repay the currencies is used as collateral, and the amount is repaid at a forward rate. The swap contracts allow the investors to utilize the funds in the currency held by him/her to pay off the obligations denominated in a different currency without suffering a foreign exchange risk.

2.         Option Transactions: The foreign exchange option gives an investor the right, but not the obligation to exchange the currency in one denomination to another at an agreed exchange rate on a pre-defined date. An option to buy the currency is called as a Call Option, while the option to sell the currency is called as a Put Option.

Thus, the Foreign exchange transaction involves the conversion of a currency of one country into the currency of another country for the settlement of payments.