Accounting for Derivatives: Using Financial Engineering to Hedge a Possible Future Foreign Contract Commitment

Note:  This project was completed on April 15, 1998 prior to the issuance of SFAS 133.

Abstract: The objective of this case is to outline to students the analysis that is necessary to design a hedging strategy for a possible foreign currency commitment. The case will use a hypothetical corporation and their project bid to a German construction company to illustrate the various strategies the firm could employ to hedge against possible foreign currency movements. Students will come to understand that different strategies in some scenarios have inherent risks that cannot be removed.

The case reduces the expected complexity of electing a strategy through the logic developed in the case questions. The logic developed in the case questions will provide students with the ability to analyze: (1) the currency exchange environment which motivated the construction firm to contact a Financial Engineer, (2) the foreign exchange rate risk that the firm could experience if the bid is successful and the effective dollar cost the firm would experience if they had not hedged this exposure, (3) two different hedging strategies that could be utilized by the firm and their related dollar costs to hedge against foreign currency movements, (4) the journal entries that would be required to record all of the transactions associated with the bid under current accounnting requirements and, (5) be able to explain in general terms how the journal entries for the same transactions would have been recorded if the recent FASB Exposure Draft on Accounting for Derivatives is passed.

Comments: please email me at akinter@trinity.edu