Memorandum
- To: Company X
- From:
- Date:
- Subject: Advantages and disadvantages of forward contracts and options
To hedge the foreign exchange risks, it is possible to use both forward contracts and options that differ in relation to their specific advantages and disadvantages.
Forward contracts are used when a company wants to set the price for the contract related to the future date. To enter this type of contract, the company does not need to cover upfront costs (Hoyle, 2014). As a result, while setting the specific price, the company protects itself from possible fluctuations in the exchange rates. The obvious advantages are in reducing the risk exposure, fixing the rates for the future, creating liquid markets, and relying on flexibility because of the customized nature of the contract (Deegan, 2013; Radebaugh, Gray, & Black, 2006). Disadvantages are associated with legal obligations to complete the contract on the set date and standardization of the contract (Schroeder, Clark, & Cathey, 2013). The company also cannot take advantage of favorable fluctuations in the exchange rates.
Call and put options also provide the company with the opportunity to set the fixed price for a specific date. Moreover, the advantage of using options is in the possibility to choose or not follow it if the rate changes to be favorable (Kaplan & Atkinson, 2015). Thus, options are more advantageous than forward contracts because of the higher level of flexibility and more available strategies to choose spot or fixed rates, but options are more expensive as the premium payment is required.
Forward Contract for the U.S. Company
For the U.S. company that plans to purchase 1,000,000 Mexican pesos on March 1, 2010, according to the forward contract conditions, the contract depends on the present value factor determined for two months. For this case, the annual interest rate equals 12%, and the associated present value factor is 0.9803. In order to state how the company could report the forward contract at the end of the year of 2009, it is important to focus on the fair value that was discounted for two months according to the 12% rate (Doupnik & Perera, 2007). Table 1 presents the calculations on using the forward contract by the U.S. company.
Table 1. Forward Contract Calculations.
In order to report the forward contract on the 31st of December, it is necessary to multiply the amount of 1,000,000 by the difference between the exchange rates set by the forward contract and focus on the present value factor (Doupnik & Perera, 2007). Thus, the amount involved x (Exchange rate at the end of the year – the entered rate) = 1,000,000 x ($0.074 – $0.084) = ($10,000) x 0.9803 = $9,803. The forward contract is reported in the balance sheet according to its fair value that was its discounted for two months at the set borrowing rate of 12%. Table 2 presents the possible journal entry for the year of 2009.
Table 2. Journal Entry
References
Deegan, C. (2013). Financial accounting theory. New York, NY: McGraw-Hill.
Doupnik, T., & Perera, H. (2007). International accounting. New York, NY: McGraw-Hill.
Hoyle, J. B. (2014). Advanced accounting. New York, NY: McGraw-Hill.
Kaplan, R. S., & Atkinson, A. A. (2015). Advanced management accounting. New York, NY: PHI Learning.
Radebaugh, L. H., Gray, S. J., & Black, E. L. (2006). International accounting and multinational enterprises. New York, NY: Wiley.
Schroeder, R. G., Clark, M. W., & Cathey, J. M. (2013). Financial accounting theory and analysis: Text and cases. New York, NY: Wiley.