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Foreign exchange risk hedges
Foreign exchange risk hedges
Tokyo Electron Device (TED) is a specialized trading company that handles mainly cutting-edge semiconductor products manufactured overseas.Most of purchase transactions are denominated in foreign currencies (U.S. dollar), so exchange rate fluctuation risks are hedged by conducting dollar-denominated sales transactions and using forward exchange contracts.
Dollar-denominated sales transactions
Major customers are Japanese companies and locally incorporated Japanese companies. TED strives to minimize the impact of exchange rate fluctuations on profits at the time of purchase by increasing the percentage of dollar-denominated sales or yen-denominated sales according to exchange rate fluctuations.
Forward exchange contracts
For foreign currency-denominated purchase and sale transactions, TED locks in profits on a yen-denominated basis at an early stage, mainly by entering into forward exchange contracts before purchasing products.
Since recorded rates (rates on occurrence) are used for foreign currency-denominated sales and purchases for accounting purposes and the difference from forward exchange contract rates are recorded as foreign exchange gains or losses at the time of settlement of receivables and payables, a large amount of foreign exchange gains or losses (non-operating gains or losses) may be presented, but a certain amount of profit is ensured in terms of ordinary income.
Example: A 15-dollar product is sold for 20 dollars when the yen is appreciating.
In the case where:
Forward exchange contract rate: USD1=JPY110
Recorded rate at the time of purchase: USD1=JPY110
Recorded rate at the time of sale: USD1=JPY120
| Profit and Loss Statement （Prevailing rate） |
Settlement of Receivables and Payables （Forward exchange contact rate） |
|
|---|---|---|
| Sales | 20×120=2,400 yen | 20×110=2,200 yen |
| Cost of sales | 15×110=1,650 yen | 15×110=1,650 yen |
| Gross profit | 2,400-1,650=750 yen | 2,220-1,650=550 yen |
| Foreign exchange loss | 200 yen | - |
| Ordinary income | 550 yen | 550 yen |
Since a forward exchange contract was concluded, actual gross profit resulting from settlement of receivables and payables is 550 yen. However, purchases and sales are recorded on the Profit & Loss Statement at rates on occurrence, so sales are recorded at the weaker yen rate compared to the rate at purchase, and gross profit amounts to 750 yen, an increase of 200 yen. On the other hand, due to settlement at the forward exchange contract rate, the same amount of a foreign exchange loss of 200 yen is recorded as non-operating expense , offsetting the increase of 200 yen.
(Example) A 15-dollar product is sold for 20 dollars when the yen is appreciating.
In the case where:
Forward exchange contract rate: USD1=JPY120
Recorded rate at the time of purchase: USD1=JPY120
Recorded rate at the time of sale: USD1=JPY110
| Profit and Loss Statement （Prevailing rate） |
Settlement of Receivables and Payables （Forward exchange contact rate） |
|
|---|---|---|
| Sales | 20×110=2,200 yen | 20×120=2,400 yen |
| Cost of sales | 15×110=1,800 yen | 15×120=1,800 yen |
| Gross profit | 2,200-1,800=400 yen | 2,400-1,800=600 yen |
| Foreign exchange income | 200 yen | - |
| Ordinary income | 600 yen | 600 yen |
Since a forward exchange contract was concluded, actual gross profit resulting from settlement of receivables and payables is 600 yen. However, purchases and sales are recorded on the Profit & Loss Statement at rates on occurrence, so sales are recorded at the stronger yen rate compared to the rate at purchase, and gross profit amounts to 400 yen, a decrease of 200 yen. On the other hand, due to settlement at the forward exchange contract rate, the same amount of a foreign exchange gain of 200 yen is recorded as non-operating income , offsetting the decrease of 200 yen.
Summary
- To hedge foreign exchange risks, TED enters into foreign exchange contracts and foreign currency-denominated sales transactions.
- In forward exchange contracts, due to the difference between the recorded rate (rate on occurrence) and the forward exchange contract rate, gross profit increases or decreases. However, the increase or decrease in gross profit is offset by recording foreign exchange gains or losses, so the impact of exchange rate fluctuations on ordinary income is minimal.
