Financial Derivatives and Foreign Currency Risk

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

Introduction

Large firms have long been concerned about the risks associated with global transaction events. Conducting business and raising capital in the current global marketplace entails several environmental market risks over which firms do not have direct control. Market risks such as fluctuations in foreign currency exchange rates, interest rates, stock prices, and commodity prices can produce material benefits/detriments to a firm’s reported operating results and cash flows. In a continuing effort to guard against the possible detriments, firms have been innovatively seeking methods to minimize market risk. Concurrently, several firms have tried to realize any probable speculative benefits from market changes. Gradually, derivative financial instruments have become choice tools for many firms to manage their financial risk. As its name suggests, a derivative financial instrument is valuable because of its direct relationship to an underlying asset or index.

Derivatives began as tools used by farmers to protect themselves from declines in grain prices. A farmer would contract to sell grain at a specified price on a specified date some time in the future. If grain prices fell, the farmer would already have secured revenues. Extrapolations from this basic contract idea have led to the development of tools for managing other types of market risk. Whether hedging away the risk of changes in currency exchange and interest rates or speculating on the potential for changes in stock rates, firms have been entering into a plethora of increasingly available derivative instruments over the last several years.

Options, forwards, futures, and swaps are the basic financial derivative instruments. While forwards and swaps must be privately negotiated, options and futures trade on the open market. The four instruments can be further tailored to meet a firm’s individual financial objectives through a host of different combinations and alterations. Options on futures, swaptions, and market spreads are simply a few of the available variations.

As the use of simple and complex derivatives has developed, recording and reporting such derivative activity has become a major issue for investors and accountants, among others. The concern arises because, recently, several establishments have reported material losses from investments as a result of derivative involvement. Several of the loss scenarios arose from speculative activity; however, many firms sustained losses while attempting to hedge risks. Sometimes the complexity of derivatives contracts yielded an additional component of risk when parties were not sufficiently clear as to the contract terms and transactions. In other cases, financial managers attempted to "fix" poor financial decisions and found themselves in even murkier waters. Other losses were simply the result of poor financial monitoring. Despite the cause, the losses surprised investors and other stakeholders. Proctor & Gamble, Gibson Greetings, and Orange County are examples of entities reporting significant losses from derivatives transactions that were previously undisclosed.

Kashima Oil and Japan Airlines reported significant fiscal 1994 losses on investments in foreign currency derivatives. Kashima Oil lost $1.45 billion in one year. Japan Airlines terminated the employment of several top executives in March 1998 for reasons including unexpected losses associated with derivatives. Circumstances surrounding these and other foreign currency derivatives losses are especially noteworthy at present, given the recent volatility of currency exchange rates.

Derivatives and Foreign Currency

Strong currency fluctuations have resulted from what has been termed the Asian flu. For over a decade, manufacturers have been developing Southeast Asian operations in countries such as Singapore, Indonesia, Malaysia, and the Philippines. These countries became globally known for inexpensive labor and cost of operations. In addition, retailers were steadily moving into the growing Asian markets. Rapid increases in demand induced Asian governments to print more local currencies. There was an abundance of cash in the Asian markets. Over time, the cost of labor rose, real estate costs increased, and the governments began to devalue their currencies. A shadow fell upon the economic outlook of these countries. Finally, on October 27, 1997, Hong Kong’s stock market, Hang Seng, crashed, and the effects were felt worldwide.

Large corporate investments in Brazil have also brought attention to this South American economy in light of the Asian flu. Systematic devaluations (of almost 20%) of the Brazilian real have several analysts worried. A significant number of other countries have experienced notable exchange rate fluctuations. The Japanese yen has suffered as a result of the country’s economic recession. The Mexican peso has a several year history of exchange rate instability. Other countries with volatile rates during the past year are Germany, Taiwan, and Great Britain.

Conducting business in and with other countries in such an environment necessitates the use of foreign currency risk management. Depending upon the scenario and the countries involved, exposure to exchange rate risk could prove beneficial or detrimental. For example, A U.S. company purchases inventory from a Japanese factory. The company will need to settle its account with the factory in yen, and must enter into a foreign currency transaction to buy yen. Without a hedge of the transaction, the firm would purchase the yen on the open market at what is called the daily spot price. If the dollar has strengthened relative to the yen between the time of contract and the time of payment ($/ at time = 1 < $/ at time = 0), the account payable will actually be cheaper in dollars to the company. In this case, the exchange rate exposure produces monetary benefits. If the company had sold inventory (selling price in yen) to the Japanese factory, it would have lost money on the conversion to dollars at the spot rate, given the same changes in the currency exchange environment. In hindsight, the company would not want to hedge its account payable to the factory, but would want to hedge its account receivable from the factory.

The problem with deciding whether to hedge or not is one of prediction error. Exchange rates could have moved in the opposite direction from that expected. Firms unwilling to bear the risk of exposure can enter into currency forwards, currency futures, or currency options. A currency forward or future would require the firm to sell (buy) a specified amount of foreign currency on a specified future date. The company would know today what its receipt (payment) of $/foreign currency would be in the future. Although the firm has successfully hedged all exchange rate risk, it has not necessarily preempted itself from a financial loss since the locked in forward rate could be unfavorable when compared to the spot rate on the future date. A currency option would provide the firm with the right, but not the obligation, to sell (buy) a specified amount of foreign currency at any time until a specified date.

A fourth type of currency derivative is the currency swap. It is a means of hedging exchange rate risk when a firm borrows in one currency but needs to borrow in a different currency. Engel Industries (England) could agree to exchange $6 million with Wacky Industries of Australia for 3 million today. Each has an option, at some future date, to require both payments to be reversed at the same exchange rate. The agreement can be structured to include the swap of interest payments as well. In essence, a currency swap arrangement entails a firm’s borrowing in one currency and lending in another.

Recording and Reporting Derivative Activity

Accounting for foreign currency and other derivatives has become something of an accounting enigma. The Financial Accounting Standards Board (FASB) has issued a series of statements in recent years that address the issue of derivative accounting directly and indirectly. Statement of Financial Accounting Standards No. 52 (SFAS 52) Foreign Currency Translations addresses accounting for foreign currency forward contracts while SFAS 80 Accounting for Futures Contracts addresses accounting for currency futures. There is no SFAS directly governing the accounting for options. SFAS 107 Disclosures about Fair Value of Financial Instruments and SFAS 119 Disclosure about Derivative Financial Instruments and Fair Value of Investments contain disclosure requirements about the fair value, nature, and term of derivative contracts.

The various SFAS statements have established helpful guidelines in as far as they address the issue of accounting for derivatives. However, inconsistencies among guidelines and application of those guidelines have hindered the reporting progress. The FASB has issued Exposure Draft 162-B Accounting for Derivative and Similar Financial Instruments and for Hedging Activities that, if passed, will supersede previous conflicting guidelines and establish standard accounting for all derivatives.

Draft 162-B introduces several accounting changes. It would require inclusion of all derivatives as assets or liabilities on the balance sheet. Derivatives would be carried at fair value, and adjusted for annual fluctuations. Recorded changes in fair value would be dependent upon whether the instrument is classified as a hedge. Changes in fair value hedges (that hedge the fair value of the underlying asset or liability) would be recognized in current earnings, and the offset assigned to the underlying item. Changes in cash flow hedges would be recorded in comprehensive income (a stockholders’ equity account). Disclosure requirements accompany the accounting guidelines for each type of derivative instrument. Risk management policies, timing of cash flows, sources and amounts of gains and losses, and risk categories must all be disclosed in the notes to the financial statements.

As the FASB addressed derivative accounting difficulties, the Securities and Exchange Commission (SEC) developed new rules for disclosure of market risk for publicly traded companies. In January 1997, the SEC issued Disclosure of Accounting Policies for Derivative Financial Instruments and Derivative Commodity Instruments and Disclosure of Quantitative and Qualitative Information About Market Risk Inherent in Derivative Financial Instruments, Other Financial Instruments, and Derivative Commodity Instruments. This statement 33-7386 requires the following disclosures: 1. descriptions of accounting policies for derivatives in the footnotes to the financial statements; 2. quantitative information about derivatives that would aid investors in assessing current and future market risk; and 3. additional qualitative information about derivatives.

The first and third requirements direct that a firm to enhance the quality of its disclosures beyond what is set forth in SFAS 119. This extension, although informative, does not present the investor with new tools with which to measure market risk. The second requirement, however, redefines the nature of disclosed information. Quantification of market risk allows investors, for the first time, to assess the net exposure of a firm’s derivative investments portfolio.

Companies are required to present quantitative portfolio market risk information by risk exposure category. For example, an aggregate for exchange rate exposure should be disclosed separately from an aggregate for interest rate risk. The SEC offers three alternatives for the quantitative disclosures: 1. tabular presentation, 2. sensitivity analysis, or 3. value at risk disclosures.

Tabular presentation, the simplest method of quantification, is offered as a less cumbersome alternative in consideration of small companies with limited derivative activity. Under this approach, companies would present fair value information of derivatives in tabular fashion, and disclose derivative contract terms sufficient to determine future cash flows. This method does not truly evaluate the earnings, fair value, and cash flow effects of potential changes in market risk categories; however, it provides investors with information to monitor the risks of simple derivative portfolios.

The sensitivity analysis alternative computes the hypothetical gain or loss in future earnings, fair values or cash flows due to hypothetical changes in interest rates, foreign currency exchange rates, and commodity prices. Companies may choose whether the sensitivity analysis will focus on impacted earnings, fair values or cash flows. After determining aggregated results based on the current environment, the firm selects a hypothetical change and reports the magnitude and directional differences (gain or loss) that would arise if the change actually occurred. Changes in interest rates, exchange rates, and other market prices are to be analyzed categorically, as displayed in Time Warner’s voluntary disclosure in its March 1996 10-Q.

Value at risk (VaR), the final alternative, aggregates the market risk of the entire portfolio into one number. This number is interpreted as the possible portfolio loss that could occur with a given probability if market changes were to occur. A VaR number would be presented for each exposure category. Ford Motor Co.’s quantitative disclosures include VaR analysis. The VaR model has become a benchmark tool in quantifying risk. Unfortunately, the cost of VaR analysis prohibits its use by smaller firms.

The SEC plans to review the effectiveness of the new regulations after the FASB issues the new statement on accounting for derivatives, and business practice establishes an accepted method of quantifying market risk.

Quanto Swap Portfolio Example

The rest of this paper is dedicated to providing the reader with an illustration of a foreign currency derivatives contract. The contract, a quanto swap, illustrates one combination of the standard derivative instruments. A quanto swap, also known as a diff swap, is a combination of the foreign currency swap and interest rate swap. Recall that the currency swap usually involves the exchange of principal and interest payments of a local firm for that of a foreign entity. In an interest rate swap, both of the firms are local and only the interest payments are exchanged. Out of the intersection of the currency and interest rate swap comes the quanto swap. This contract involves the exchange of interest payments of a local firm for that of a foreign entity. The local firm will pay interest at the foreign interest rate, but its notional will be held in the local currency.

Based upon the terms of the quanto swap contract, a hypothetical scenario is used as the basis for determining the foreign currency exposure and quantifying the portfolio risk of Inka Co.:

Inka, a U.S. manufacturer can borrow locally at a variable rate of LIBOR + .0075 and fixed rate of 9.5%. It enters two $1,000,000 loan contracts, each maturing in eight years. One loan contract entails annual fixed rate interest payments; the other entails annual variable rate interest payments. LIBOR is currently at 8.0%. Inka enters into two quanto swap agreements, one with a counterparty in Japan and the other with a counterparty in Germany. Inka must settle its swap interest payables in the respective foreign currencies; its swap interest receivables are denominated in dollars. Inka’s motivation for entering into the Japanese swap (swap 1) differs from the motivation to enter into the German swap (swap 2). Inka would like to establish a cash flow hedge of its interest rate risk in swap 1, and a fair value hedge of its interest rate risk in swap 2. Therefore, Inka swaps its variable interest rate for a fixed rate of 9.25% in swap 1; in swap 2, Inka exchanges its fixed rate for a variable rate of LIBOR + .01. In both swap cases, Inka believes that the dollar will strengthen against the foreign currency; therefore, it does not hedge any $/ or $/DM exchange rate risk. (The current exchange rates are $0.007677/ and $0.5486/DM.) Click here to view input data in tabular form.

Under the terms of swap one (cash flow hedge), Inka will pay a net annual fixed interest rate of 9.25%. Inka delivers the variable interest payments it receives from the Japanese counterparty to the local bank, thereby neutralizing its exposure to variable interest rates. At the same time, Inka delivers its fixed rate interest payments to the counterparty. Although the interest rate is fixed, interest settlement payments (payable in yen) are subject to unhedged currency exchange fluctuations. Inka’s annual variable interest receipts are not subject to exchange rate risk, since they are received in dollars. Similarly, Inka’s variable rate loan from the local bank is not subject to currency risk because the principal remains in the local currency.

Under the terms of swap two (fair value hedge), Inka will pay a net annual variable rate of LIBOR + .01. Inka receives fixed interest payments at 9.5% from the German counterparty, and immediately delivers those payments to the local bank. Inka also delivers variable interest payments to the counterparty. As is the case with swap one, the interest payable cash flows are subject to currency risk.

Click here to view inital cash settlement data from the two quanto swaps (without any changes in LIBOR or currency rates).

In order to achieve the desired fair value hedge in swap two, Inka must pay the variable LIBOR rate. Interest payments will fluctuate as LIBOR fluctuates; however, the fluctuation will change both the fair value of the swap and the fair value of the debt. As interest rates rise, the swap (an asset) becomes less valuable since it is unfavorable for Inka to pay an increasing variable interest rate. For similar reasons, Inka's fixed rate debt (a liability) becomes more valuable. The two changes in value will offset each other. Note that the sum of the debt and swap fair values will equal the initial principal amount of $1,000,000. Both swap and debt fair values are exposed to exchange rate risk. Click here to view debt and swap fair values for swap 2, given a 1% annual increase in LIBOR and constant exchange rates.

Consider the scenario in which interest rates rise by .5% every year while exchange rates remain constant over time. The change in variable interest rates will not affect Inka’s net cash flows under swap one. The increase in interest payable to the bank is offset by the increased receivable amount from the Japanese counterparty. The change will affect cash flows under swap two. Net cash payments under swap two will increase by $1,000,000*.005 (or $5,000) annually. Click here to view cash settlemtent data from the two quanto swaps.

Click here to view the cash flow graph for swap one.

Click here to view the cash flow graph for swap two.

Now consider the scenario in which variable interest rates do not change over time, but exchange rates reflect the weakening of the dollar by 2% per year. Net cash payments increase annually for both quanto swaps, as both interest payable amounts are subject to exchange rate risk. Click here to view cash settlement data from the two quanto swaps.

Click here to view the cash flow graph for swap one.

Click here to view the cash flow graph for swap two.

The fair values of each quanto swap also vary according to interest rate and exchange rate fluctuations. Fair value calculations require computation of the present value of future cash receipts and payments, adjusted for any currency rate changes and current cash settlements. Fair values for debt and swap items are presented assuming that both the interest rate and exchange rate changes occur. Although the exchange rate has a dampening effect on swap one, its fair value begins to increases as variable interest rates increase. As LIBOR continues to increase, it is increasingly more valuable to pay a fixed interest rate. The fair value of swap two begins to decrease. Inka is paying increasingly higher interest payments due to LIBOR increases, augmented by the effect of the weakening dollar. In addition, note the constant swap + debt fair value under swap 2 (fair value hedge), but not under swap 1 (cash flow hedge). Click here to view debt and swap fair values.

Click here to view cash settlement data for the two quanto swaps.

Click here to view the fair value graph for swap one.

Click here to view the fair value graph for swap two.

Heretofore, each quanto swap has been addressed individually. However, investors are usually more interested in portfolio exposure. If interests rates were to rise by .5% per year and the exchange rates were to increase by 2% per year, portfolio results would be as follows:

Click here to view partial balance sheet and income statement effects.

Some items to note on the partial balance sheet and income statement are:

  1. Inka must recognize gain or loss each year on foreign currency rates since the exposure was not hedged.
  2. Inka can charge any other changes in fair value of the cash flow hedge to comprehensive income, thereby bypassing earnings.
  3. Balance sheet amounts are shown at fair value. The fair value of the swap + fixed–rate debt remains constant while the swap + variable –rate debt adjusts each year. The quanto swaps are carried and marked to fair value each year.

    Click here to view the cash flow graph for the swap portfolio.

    Click here to view the fair value graph for the swap portfolio.

Finally, interest rates and exchange rates are likely to fluctuate positively and negatively over time. The above scenarios assume continuing negative movements in market rates. This is often not the case in the current business environment. A last example illustrates the potential for significant positive and negative changes in portfolio results from one year to the next.

Click here for input data.

Click here to view the cash flow graph for the swap portfolio.

Click here to view the fair value graph for the swap portfolio.

Click here to view a partial balance sheet and income statement.

Conclusion

The use and complexity of derivative instruments will continue growing. Managers must learn to effectively manage the risk associated with derivatives; accountants must learn to accurately account for and disclose derivative activity; investors must strive to understand and evaluate the risks and benefits of using financial derivative instruments.

Reviewing the derivative reporting and disclosures of various firms is beneficial in cementing understanding of the issues at hand. A good exercise for the reader would be to visit the Edgar Database at the SEC website where annual 10-K reports can be found for any publicly traded company of choice.

 

 

 

 

 

References

Chance, Don M. An Introduction to Derivatives. Harcourt Brace College Publishers: Orlando, 1995.

ED 162-B, "Accounting for Derivative and Similar Financial Instruments and for Hedging Activities," FASB, 1996, http://www.rutgers.edu/Accounting/raw/fasb/draft/derhed/derhed01.html.

SFAS 52, "Disclosure about Fair Value of Financial Instruments," FASB, http://www.rutgers.edu/Accounting/raw/fasb/st/summary/stsum52.htm.

SFAS 80, "Accounting for Futures Contracts," FASB, http://www.rutgers.edu/Accounting/raw/fasb/st/summary/stsum80.htm.

SFAS 107, "Disclosures about Fair Value of Financial Instruments," FASB, http://www.rutgers.edu/Accounting/raw/fasb/st/summary/stsum107.htm.

SFAS 119, "Disclosure about Derivative Financial Instruments and Fair Value of Financial Instruments," FASB, http://www.rutgers.edu/Accounting/raw/fasb/st/summary/stsum119.htm.

Hamilton, David P. "Wobbly Japan Inc. Unlikely to Streamline Soon --- Weak Outlook for Profits Is Expected to Continue; Top Officers Step Down." Wall Street Journal 26 Mar. 1998, Eastern ed.:A14.

Kenyon, Alfred. Currency Risk Management. John Wiley & Sones, Inc.: New York, 1981.

Linsmeier, Thomas J. and Pearson, Neil D. "Quantitative disclosures of market risk in the SEC."Accounting Horizons 11.1 (Mar 1997): n. pag. Online. ProQuest Direct. 2 Mar. 1998.

Schroeder, Richard and Clark, Myrtle. Accounting Theory, 6th edition. John Wiley & Sons, Inc.: New York, 1998.

Welsh, James. "World economies weather the Asian flu." World Trade 11.1 (Jan 1998): n. pag. Online. ProQuestDirect. 9 Feb. 1998.

Wilson, Arlette C. and Smith, G. Robert. "Proposed Accounting for Derivatives: Does it Address the Concerns of Current Accounting?" Accounting Horizons 11.3 (Sep 1997): 69-78.