Global Finance 357patterns of gains and losses in Exhibit 12.1, and the nature of exchange rates,
assume that Fashionhouse recorded a 100,000 krone purchase when the ex-
change rate for the krone was $0.1180. That is, it takes 11.8 cents to purchase
one krone. This expression of the exchange rate, dollars per unit of the foreign
currency, is referred to as the direct rate.Alternatively, expressing the rate in
terms of kroner per dollar is referred to as the indirect rate.In this case, the
indirect rate is 1/0.1180, or K8.475. It requires 8.475 kroner to purchase one
dollar. Both the direct and indirect rates are typically provided in the tables of
exchange rates found in the financial press. The rates at which currencies are
currently trading are called the spot rates.
When Fashionhouse records the invoice received from its Danish sup-
plier, it must do so in its U.S. dollar equivalent. With the direct rate at $0.1180,
the dollar equivalent of K100,000 is $0.1180 × K100,000, or $11,800. That is,
Fashionhouse records an addition to inventory and an offsetting account
payable for $11,800. Assume that Fashionhouse pays this obligation when the
dollar has fallen to $0.1190. It will now take $11,900 dollars to acquire the
K100,000 needed to pay off the account payable. The combination of liability
exposure and a decline in the value of the dollar results in a foreign-currency
transaction loss. This result is summarized below:
The exchange rate is $0.1190 when the account payable from the purchase is
paid.
Dollar amount of obligation at payment date, 100,000× $0.1190 $11,900
Dollar amount of obligation at purchase date, 100,000 ×$0.1180 11,800
Foreign exchange transaction loss $ 100
The dollar depreciated against the krone during the time when Fashionhouse
had liability exposure in the krone. As a result, it took $100 more to discharge
the account payable than the amount at which the liability was originally
recorded by Fashionhouse.
If the foreign exchange losses incurred were significant, it might prove
difficult to pass on this increased cost to Fashionhouse customers, and it could
cause its furniture to be somewhat less competitive than that offered by other
U.S. retailers with domestic suppliers. Fashionhouse might attempt to avoid
the currency risk by convincing its Danish suppliers to invoice it in the dollar.
However, this means that the Danish suppliers would bear the currency risk.
EXHIBIT 12.1 Type of foreign currency
exposure.Change in Foreign Exposure
Currency Value Asset Liability
Appreciates Gain Loss
Depreciates Loss Gain