Question

1. what are the basic types of hedge transactions? how do they differ from each other?

2. what does "Net Settlement" mean?

3. Criticize the following statement: "Exchange losses arise from foreign import activities, and exchange gains arise from foreign export activities"

4. what are foreign currency commitments? why are they considered special?

5. explain the circumstances under which fair value hedge accounting should be used and when cash-flow hedge accounting should be used

Answer 1

1: There are three main types of hedging transactions in foreign operations: Cash flow hedges, fair value hedges, and net investment hedges.

A fair value hedge protects against changing values of assets or liabilities, while a cash value hedge protects against adverse changes in cash flows

Whereas hedge of a net investment in a foreign operation is a hedge of the foreign currency exposure arising from the reporting entity's (generally, the group's) share in the net assets of that foreign operation.

2: Net settlement means that the parties to und er derivative contract settle the contract without delivering the underlying commodity.

3: "Exchange losses arise from foreign import activities"

This statement is partially correct, as exchange losses can also arise from foreign export activities.

Example:

On May 5,2020 ,Mr X entered into a contract to export goods worth 200,000 dollars from Indian to U.S.A on September 4 ,2020.

At the time of contract, the exchange rate is 1 dollar: Rupees 70

But when the actual export took place on September 4,2020, the exchange rate falls down to 1 dollar: Rupees 65.

Hence the loss would be:

Amount of rupees expected to be received at the time of contract-amount of rupees received at the time of actual delivery of export

: 200,000 dollars*70 - 200,000*65

: 1,000,000 dollars

"exchange gains arise from foreign export activities"

This statement is also partially correct.

Exchange gains can also arise from foreign import activities.

Example:

At the time of contract of import, suppose the exchange price is 1 dollar: Rupees 60

And Mr X entered into contract of import of goods for 200,000 dollars.

At the time of actual delivery and payment the exchange rate falls to 1dollar: Rupees 55

Hence gain :

: Amount expected to be paid at the time of contract- amount actually paid at the time of delivery of import.

: 200,000dollars * 60- 200,000 dollars* 55

: 1,000,000 dollars.

4:

Foreign Currency Commitment:- Introduction
I.   Foreign Currency Commitment means, with respect to each Foreign Currency Lender, the commitment of such Foreign Currency Lender in an aggregate principal amount at any time outstanding of up to such Foreign Currency Lender’s Applicable Percentage of the Foreign Currency Committed Amount (i) to make Foreign Currency Loans in accordance with the provisions of Section 3.1(a) and (ii) to purchase participation interests in the Foreign Swingline Loans in accordance with the provisions of Section 3.3(d)
II.   Foreign Currency Commitment means, with respect to each Foreign Currency Lender, the commitment of such Foreign Currency Lender to make Foreign Currency Loans hereunder, expressed as an amount representing the maximum aggregate amount of such Foreign Currency Lender’s Foreign Currency Loans hereunder, as such commitment may be (a) reduced from time to time pursuant to Section 2.08 and (b) reduced or increased from time to time pursuant to assignments by or to such Lender pursuant to Section 10.04.
III.   Examples of Foreign Currency Commitment
•   The Foreign Currency Commitment Unused Fee shall commence to accrue on the Closing Date and shall be due and payable in arrears on the last Business Day of each March, June, September and December (and any date that the Foreign Currency Committed Amount is reduced as provided in Section 4.4 and the Maturity Date) for the immediately preceding quarter (or portion thereof), beginning with the first of such dates to occur after the Closing Date.
•   The amount of principal and interest paid on the Foreign Currency Loans prior to receipt of the proceeds of a sale of participations therein shall be shared by the Foreign Currency Lenders pro rata based on the amount of the Foreign Currency Commitment of each (or if the Foreign Currency Commitments shall have terminated, based on the Foreign Currency Loans held by each).

B.   The country's exporters deposit foreign currency into their local banks. They transfer the currency to the central bank. Exporters are paid by their trading partners in U.S. dollars, euros, or other currencies. The exporters exchange them for the local currency. They use it to pay their workers and local suppliers. The banks prefer to use the cash to buy sovereign debt because it pays a small interest rate. The most popular are Treasury bills because most foreign trade is done in the U.S. dollar due to its status as the world's currency. Banks are increasing their holdings of euro-denominated assets, such as high-quality corporate bonds. That continued despite the euro zone crisis. They'll also hold gold and special drawing rights. A third asset is any reserve balances they've deposited with the International Monetary Fund.
•   First, countries use their foreign exchange reserves to keep the value of their currencies at a fixed rate. A good example is China, which pegs the value of its currency, the yuan, to the dollar. When China stockpiles dollars, it raises the dollar value compared to that of the yuan. That makes Chinese exports cheaper than American-made goods, increasing sales.
•   Second, those with a floating exchange rate system use reserves to keep the value of their currency lower than the dollar. They do this for the same reasons as those with fixed-rate systems. Even though Japan's currency, the yen, is a floating system, the Central Bank of Japan buys U.S. Treasurys to keep its value lower than the dollar. Like China, this keeps Japan's exports relatively cheaper, boosting trade and economic growth. Such currency trading takes place in the foreign exchange market.
•   A third and critical function is to maintain liquidity in case of an economic crisis. For example, a flood or volcano might temporarily suspend local exporters' ability to produce goods. That cuts off their supply of foreign currency to pay for imports. In that case, the central bank can exchange its foreign currency for their local currency, allowing them to pay for and receive the imports.

5) A fair value hedge should be used when one is aiming to take investment position to protect the fair value of a specific asset, liability or unrecognised company commitment from risks that can affect their profit and loss accounts. This is one of the three main hedge types allowed for hedge accounting.

When there is risk of changes in cash flows associated with a recognized asset or liability or a probable forecast transaction the Cash flow hedge accounting should be used. It is one of the three hedging arrangements recognized by accounting standards.