Question

1.

a) How is the fair value of a Forward Contract determined by U.S. GAAP?

b) Yelton Co. just sold inventory for 80,000 euros, which Yelton will collect in sixty days. Briefly describe a hedging transaction Yelton could engage in to reduce its risk of unfavorable exchange rates

. c) What happens when a U.S. company sells goods denominated in a foreign currency and the foreign currency depreciates?

Answer 1

Ans 1 a)The fair value of a Forward Contract as per US GAAP is determined by comparing the difference between the contracted forward rate and the currently available forward rate for contracts expiring on the same date. On the initial date of the contract, this would result in a fair value of $0. As time passes, the currently available forward rate will likely fluctuate relative to the "fixed" contracted forward rate, creating a difference that must be accounted for as a gain or loss on the forward contract. A contract with a net gain over its life is recorded on the balance sheet asa Forward Contract Asset. A contract with a net loss over its life is recorded on the balance sheet as a Forward Contract Liability.

b)Yelton should enter into a 2 months forward contract for selling its 80000euros for specified US $ rate which will be known at the time of entering in to contract.as he sold inventory worth 80000 euro to be received after 60days if he expects that the dollar/Euro exchange rate will decrease. If he doesnot expect the dollar fall against euro, then he should not enter into a forward contract and wait for the time generally without hedging.

c) If the U.S. company sells goods denominated in a foreign currency and the foreign currency depreciates, then the company will incurr huge loss in the terms of its own currency since he will be paid less in terms of its own currency by bank at the time of exchange rate prevailing on the date of payment. Example: Suppose, at present euro/dollar rate is 0.85euro. Now if euro falls against dollar and comes to 0.95euro then if payment to be received is 100000euro then you will get 100000/.95 = $105263.15 (approx) in comparison to 100000/0.85 i.e. $117647.05(approx).

I hope you got the point. In case of any clarification please feel free to ask.