Question

Discuss the accounting treatment given various types of foreign currency hedges.

Answer 1

Accounting treatment given for various types of Foreign currency hedges:

Foreign currency hedging involves the purchase of hedging instruments to offset the risk posed by specific foreign exchange positions. hedging is accomplished by purchasing an offsetting currency exposure. for Example., if a company has a liability to deliver one million euros in six months,it can hedge this risk by entering into a contract to purchase 1 million euros on the same date, so taht it can buy and sell in the same currency on the same date. here the several ways to engage various foreign currency hedging.

1. Loan denominated in a foreign currency: When a company is at the risk of recording a loss from the translation of assets & liabilities into its home currency, it can hedge the risk by obtaining a loan denominated in the functional currency in which the assetsand liabilities are recorded. the effect this hedge is to neutralized any loss on translation of the subsidiary's net assets with a gain on translation of the loan, or vice versa.

2. Forward Contracts: A forward contract is an agreement under which the business agrees to buy a certain amount of foreign currency on a specific future date,and at a pre determined exchange rate. by entering into the Forward contract the company ensures that definite future liability can be settled at a specific exchange rate.

3. Future Contracts: A Future contracts is a similar in concept of Forward contract, in that a business can enter in to contract to buy or sell currency at a specific price on a future date. the difference is the futures contracts are traded on an exchange, so these contracts are for standard amount and durations.

4.Currency Options: An option gives its owner the right, but not the Obligation to buy or sell an asset at a certain price (known has been strick price). either on before a specific date.

5.Cylinder Option: 2 Options can be combined  to create a cyllinder option. one option is priced above the current spot price of the target Currency, while the other option is priced below the spot price. the gain from exercising one option is used to partially offset the cost of other option, there by reducing the overall cost of the hedge.

One should decide what proportion of risk exposure to hedge, such as 100% of the booked exposure or 50% of the forecated exposure. This gradually declining benchmark hedge ratio for forecasted periods is justifiable on the assumption that the level of forecaste accuracy declines over time, so atleast hedge against the minimum amount of exposure that is likely to occur. A high-confidence currency forecast with little expected volatility should be matched with a higher benchmark higher ratio hedge ratio, while a questionable forecast might justified a much lower ratio.