Accounting for Derivatives: The Case of a Currency Rate Swap Used to Hedge Foreign Exchange Bate Exposure.

The objective of this case is to provide students with an example of the analysis necessary to prepare and evaluate accounting for a derivative transaction used by Atlantic Richfield Company (Arco) to hedge foreign exchange rate exposure. The case is designed primarily to enhance students' ability to solve this type of problem and secondarily to introduce current accounting issues related to derivatives. In 1986, Arco borrowed yen in the Eurobond market and simultaneously created a synthetic dollar borrowing by agreeing to a yen-for-dollar currency swap. The goal of the transaction was to obtain a lower dollar borrowing cost than they would have been able to obtain by borrowing in dollars directly. The case reduces the expected complexity of accounting for derivatives through the logic developed in the case questions. The logic developed in the case questions will provide students with the ability to understand: (1) the international interest rate environment which motivated Arco to borrow in yen; (2) foreign exchange rate risk, including the effective dollar cost of the yen debt if Arco did not hedge this exposure; (3) how the cash flows of the currency swap interact with the cash flows of the debt to hedge the foreign exchange risk, (4) how entering into the currency swap mitigates currency risk, but exposes Arco to counterpary credit risk and legal risk; (5) the attributes of accounting and reporting for the debt and currency swap as separate instruments or as a combined synthetic instrument; and (6) accounting for the currency swap at fair value.