FX forwards are foreign currency derivative contracts that allow the exchange of currencies at a future date for a fixed forward rate. Forwards of the same maturity but contracted at different times have different forward rates due to the constant change in spot rate. A change in current forward rate increases or decreases earlier contracts' relative exchange value at maturity. Such a change in value when discounted back to current time is referred to as a forward contract's current fair value. The Financial Accounting Standards Board requires FX forwards be carried on the balance sheet at their fair value.
Calculate forward rate change and currency exchange difference at maturity. Suppose a FX forward was entered into on December 1, 2009 to exchange 10,000 euros for U.S. dollars on March 1, 2010 at a forward rate of 1 euro = 1.5000 dollars. One month later on December 31, 2009, new forward contracts of the same maturity have a forward rate of 1 euro = 1.4000 dollars. The forward rate difference is 1.5 - 1.4 = 0.1 dollar per euro and the currency exchange difference at maturity is $0.1 per euro x 10,000 euros = $1,000 dollars.
Compute fair value of the forward contract. Discount the currency exchange difference of $1,000 from March 1, 2010 back to December 31, 2009. Assume a discount rate of 12 percent annually. Since the discount periods are two months from March 1 back to December 31, the rate applied is 1 percent (12 percent/12). The present value or fair value of the forward contract is solved to be $980.30, manually through 1000/(1 + 1 percent)(1 + 1 percent) or using a financial calculator.
Record fair value of the forward contract on balance sheet. The forward's fair value of $980.30 is recorded as an asset on the balance sheet when books are closed on December 31. For forwards that have a decrease in fair value, a liability is recorded. Gain or loss from change in a forward's fair value is recognized in either net income or accumulative other comprehensive income (AOCI) in the equity section.
To help identify the nature of the forward rate change, make the following comparison: on March 1, 2010, the contract from December 1 can exchange 1 euro for 1.5000 dollars while new contracts from December 31 can exchange 1 euro for only 1.4000 dollars. Therefore, the rate change increases the fair value of the contract from December 1.
Note that at a forward's contracting time, the forward has a fair value of zero as there is no forward-rate differential between this contract and others entered into at the same time.
The gain or loss recognition depends on the nature of the forward. If the forward is used for speculation, include gain or loss in net income. If the forward is used for a fair value hedge, enter gain or loss also in net income. If the forward is used for a cash flow hedge, recognize gain or loss in AOCI.
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