Hedging Foreign Exchange Risk

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CASE 3.4
Hedging a Highly Expected Foreign Sale with a Knock-in Forward
In Cases 2 and 3, we analysed hedging strategies of highly expected foreign sales built with
vanilla options. The hedging instrument used in this case, a knock-in forward, involves an
exotic option. At the moment, the IFRS accounting treatment of exotic options is unclear.
A potential solution is to split the exotic instrument into two parts: a first part that involves
a group of standard derivatives for which the accounting treatment is clear, and a second
part that includes the rest. The first part is eligible for hedge accounting and the second part
is treated as undesignated. This process of splitting the exotic instrument into the two parts
is quite challenging as it generally turns out to be different solutions. Therefore, readers
seeking an optimal accounting solution to be etched in stone are bound to be disappointed.
Our objective is that the reader develops and exercises his own judgment.
The risk being hedged in this case is the same as in the previous cases. Let us assume
that on 1 October 20X4 ABC Corporation, a company whose functional currency was the
EUR, was expecting to sell finished goods to a US client. The sale was expected to occur
on 31 March 20X5, and the sale receivable was expected to be settled on 30 June 20X5.
Sale proceeds were expected to be USD 100 million to be received in USD.
ABC had the view that the USD could appreciate against the EUR in the following
months and wanted to benefit were its view right. However, ABC thought that the USD
appreciation was going to be quite limited, not reaching 1.1620. At the same time, ABC
wanted to have a protection, were its view wrong. As a consequence, on 1 October 20X4
ABC entered into a knock-in forward with the following terms:

FX Knock-in Forward Terms

ABC has the right to sell the USD notional and to buy the EUR notional
at 1.2600 on maturity date.
If at any moment from start date until maturity date the USD/EUR spot
rate does trade at, or below, the barrier, the right becomes an obligation.
Start date
Counterparties
Maturity
USD notional
EUR notional
Strike Rate
Barrier
Premium
Settlement

1 October 20X4
Company ABC and XYZ Bank
30 June 20X5
USD 100,000,000
EUR 79,365,000 (if barrier is reached)
1.2600
1.1620
Zero
Physical delivery

The knock-in forward guaranteed an exchange rate slightly worse than that of standard
forward but, in contrast, it allowed ABC a better exchange rate provided the spot rate
did not reach 1.1620. On expiry, ABC had the right to exchange USD for EUR at a rate
of 1.2600. In the event that the spot USD/EUR exchange rate ever traded at or below
1.1620 during the instruments life, ABCs right became an obligation to exchange USD