Question

Forward exchange contract designated as a fair value hedge of foreign currency risk in a foreign-currency-denominated available-forsale debt security, weakening $ US On November 1, 2021, our company purchased a foreign-currency-denominated AFS debt security for €420,000. Our company plans to sell the security in three months (i.e., on January 31). The spot rate on the date the security is purchased is $1.28:€1 and the company is concerned about the prospect of a strengthening $US that will reduce the $US fair value of the foreign-currency-denominated security. To hedge this risk, the company purchases a forward contract to sell €420,000 for $1.31:€1 (the current forward rate) on January 31, 2022. Our U.S.-based company's functional currency is the $US. The spot and forward exchange rates and their effects on the recorded values of AFS security and the forwardcontract derivative are summarized in the following table: a For settlement on January 31,2022 b

Ignore discounting in the computation of fair values. a. Prepare the journal entries to record the purchase and all adjustments required for the AFS security and the forward contract at November 1 , 2021 , December 31, 2021, and January 31, 2022. FV Hedge b. Reconcile to the forward rate at the forward contract's inception the net cash received for both the sale of the AFS security and the settlement of the forward-contract derivative. Net cash received for sale of the AFS security and settlement of the forward contract derivative is: $

Answer 1

Hedging through financial contracts helps firms mitigate currency risk from contracts denominated in foreign currencies. When international financial investors demand more U.S. dollars.

Step-by-step explanation:

Many portfolio investment decisions involve hedging to protect against movements in exchange rates. For example, a U.S. firm with a contract to receive 1 million euros in the future may not know the contract's worth in U.S. dollars due to potential fluctuations in the dollar/euro exchange rate.

To mitigate this uncertainty, the firm can enter into a financial contract (such as a forward exchange contract), guaranteeing a certain exchange rate at a set date in the future.

Financial institutions or brokerage companies often handle the logistics of hedging, where they earn revenue through service fees or by creating a spread in the exchange rate.

When international financial investors demand more U.S. dollars to purchase U.S. government bonds, the supply of U.S. dollars in foreign exchange markets decreases.

This shift in demand and supply can lead to an appreciation of the U.S. dollar against other currencies. Understanding these dynamics is crucial for businesses and investors navigating the complications of international trade and foreign exchange markets.