Dell Computer Corporation

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Dell Computer Corporation
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What is Dells Foreign Exchange Risk?

• Component and manufacturing costs in USD.
• Revenue in foreign currencies.
• Is this transaction risk, economic risk, or both?

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Example

• Cost of goods sold USD 20M
• Sales (at local market prices) DEM 36M
• Gross profit _at_ 1.50 DEM/USD USD 24M - USD 20M
  USD 4M
• Gross profit _at_ 2.00 DEM/USD USD 18M - USD 20M
  USD -2M

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Hedging Alternatives

• Forward sale contract
• Purchased put option
• Written call option
• Synthetic forwards
• Range forwards

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Forward Sale Contract

• 14 January 1992 6-month forward rate 1.6364
  DEM/USD
• Revenue DEM 36M USD 22.00M
• Gross profit USD 2.00M

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Purchased Put Option

• 14 January 1992 6-month puts with 1.5873 DEM/USD
  strike price .0284 USD/DEM
• Revenue DEM 36M USD 22.68M
• Gross profit USD 2.68M
• Cost of put USD 1,022,400
• Net USD 1.66M

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Written Call Option

• 14 January 1992 6-month calls with 1.5873 DEM/USD
  strike price .0165 USD/DEM
• Revenue DEM 36M USD 22.68M
• Gross profit USD 2.68M
• Revenue from call USD 594,000
• Net USD 3.27M
• Is this a hedge?

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Synthetic Forwards

• 14 January 1992 6-month puts with 1.5873 DEM/USD
  strike price .0284 USD/DEM
• 14 January 1992 6-month calls with 1.5873 DEM/USD
  strike price .0165 USD/DEM
• Revenue DEM 36M USD 22.68M
• Gross profit USD 2.68M
• Cost of put USD 1,022,400
• Revenue from call USD 594,000
• Net USD 2.25M

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Range Forwards

• 14 January 1992 6-month puts with 1.6949 DEM/USD
  strike price .0107 USD/DEM
• 14 January 1992 6-month calls with 1.5385 DEM/USD
  strike price .0116 USD/DEM
• Revenue DEM 36M USD 21.24M and USD 23.40M
• Gross profit USD 1.24M and USD 3.40
• Cost of put USD 385,200
• Revenue from call USD 417,600
• Net USD 1.27M and USD 3.43

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Hedge Summary

• Forward Sale Contract USD 2.00M
• Purchased Put Option USD 1.66M
• Written Call Option USD 3.27M
• Synthetic Forwards USD 2.25M
• Range Forwards USD 1.27M and USD 3.43

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Hedging Problems

• The DEM 36M revenue is subject to market risk.
• Forward contracts must be executed
• Written call options must be executed
• Purchased put options can be abandoned

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Accounting Background
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Types of Hedged Transactions

• Hedge of a recognized foreign currency
  denominated asset The foreign subsidiary has
  purchased the computers and is hedging the
  payable.
• Hedge of an unrecognized foreign currency firm
  commitment The foreign subsidiary has committed
  to purchasing the computers and is hedging the
  payable that will be created when it does.
• Hedge of a forecasted foreign currency
  denominated transaction The foreign subsidiary
  plans to purchase computers and is hedging their
  anticipated cost.

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Fair Value of Derivatives

• The fair value of a forward contract is the
  difference between the contract forward rate and
  the current forward market rate for the same
  maturity date, multiplied by the amount of the
  contract, discounted to maturity at the
  incremental borrowing rate.
• The fair value of an over-the-counter options
  contract is determined by the Black-Scholes
  options pricing model
• The fair value of a futures contract or
  exchange-traded options contract is the current
  market price.

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Changes in Fair Value

• Changes in fair value of derivatives used for
  speculation are recognized initially on the
  income statement as part of net income.
• Accounting for changes in the fair value of
  derivatives used for hedging depends on the
  nature of the foreign exchange risk being hedged
  and on whether the derivative qualifies for hedge
  accounting.
• Changes in fair value of derivatives may
  sometimes be recognized initially on the balance
  sheet as a component of accumulated other
  comprehensive income (AOCI - income deferred in
  stockholders equity).

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To Qualify for Hedge Accounting

• The derivative is used to hedge either a fair
  value exposure or cash flow exposure to foreign
  exchange risk (nature of the hedged risk).
• The derivative is highly effective in offsetting
  changes in the fair value or cash flows related
  to the hedged item (hedge effectiveness).
• The derivative is properly documented as a hedge
  (hedge documentation).

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Nature of the Hedged Risk

• A fair value exposure exists if changes in
  exchange rates can affect the fair value of an
  asset or liability reported on the balance sheet.
  To qualify for hedge accounting, the fair value
  risk must have the potential to affect net income
  if it is not hedged.
• A cash flow exposure exists if changes in
  exchange rates can affect the amount of cash flow
  to be realized from a transaction with changes in
  cash flow reflected in net income.
• A cash flow exposure exists for (1) recognized
  foreign currency assets and liabilities, (2)
  foreign currency firm commitments, and (3)
  forecasted foreign currency transactions.
• Derivatives for which companies wish to use hedge
  accounting must be designated as either a fair
  value hedge or a cash flow hedge.

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Hedge Effectiveness

• The hedge actually must be effective in
  generating offsetting gains and losses for hedge
  accounting to continue to be applied.
• At inception, a foreign currency derivative can
  be considered an effective hedge if the critical
  terms of the hedging instrument match those of
  the hedged item.
• Critical terms include the currency type,
  currency amount, and settlement date.

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Hedge Documentation

• Hedge accounting requires formal documentation at
  the inception of the hedge.
• The hedging company must prepare a document that
  identifies the hedged item, the hedging
  instrument, the nature of the risk being hedged,
  how the hedging instruments effectiveness will
  be assessed, and the risk management objective
  and strategy for undertaking the hedge.

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Recognized Foreign Currency Assets and Liabilities

• Qualifies as a cash flow hedge if it completely
  offsets the variability in the cash flows
  associated with the foreign currency receivable
  or payable.
• Qualifies as a fair value hedge if it does not
  qualify as a cash flow hedge or if it is
  designated as a fair value hedge.

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Cash Flow Hedge

• The hedged asset or liability is adjusted to fair
  value based on changes in the spot exchange rate,
  and a foreign exchange gain or loss is recognized
  in net income.
• The derivative hedging instrument is adjusted to
  fair value (resulting in an asset or liability
  reported on the balance sheet) with the
  counterpart recognized as a change in accumulated
  other comprehensive income (AOCI).
• An amount equal to the foreign exchange gain or
  loss on the hedged asset or liability is then
  transferred from AOCI to net income the net
  effect is to offset any income statement gain or
  loss on the hedged asset or liability.
• An additional amount is removed from AOCI and
  recognized in net income to reflect (a) the
  current periods amortization of the original
  discount or premium on the forward contract or
  (b) the change in the time value of the option.

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Fair Value Hedge

• The hedged asset or liability is adjusted to fair
  value based on changes in the spot exchange rate,
  and a foreign exchange gain or loss is recognized
  in net income.
• The derivative hedging instrument is adjusted to
  fair value (resulting in an asset or liability
  reported on the balance sheet), with the
  counterpart recognized as a gain or loss in net
  income.

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Forward Contract Example(Subsidiary Hedges
Payable)

• On 1 October 1992, Dells German subsidiary
  purchases computers for USD 20M with payment in 6
  months on March 31, 1993.
• Simultaneously, the subsidiary makes a forward
  contract to purchase USD 20M in 6 months at a
  rate of 1.4448 DEM/USD.
• The current spot rate is 1.4260 DEM/USD

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Rates and Values
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Cash Flow Hedge - October 1
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Cash Flow Hedge - December 31
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Cash Flow Hedge - December 31
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Cash Flow Hedge - December 31
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Cash Flow Hedge - December 31
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Quarterly Income Statement
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Balance Sheet
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Cash Flow Hedge - March 31
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Cash Flow Hedge - March 31
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Cash Flow Hedge - March 31
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Cash Flow Hedge - March 31
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Cash Flow Hedge - March 31
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Cash Flow Hedge - March 31
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Fair Value Hedge

• All gains and losses on the account payable and
  on the forward contract appear on the income
  statement.
• In effect, the costs of buying on credit and
  hedging versus paying cash appears as a foreign
  exchange loss rather than an increase in the cost
  of inventory and subsequently a higher cost of
  goods sold.
• To what can you attribute the gains and losses?

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Options Example (Subsidiary Hedges Payable)

• At-the-money and in-the-money options can be
  designated cash flow hedges, since they
  completely offset the variability in the cash
  flows associated with the foreign currency
  receivable or payable.
• Out-of-the-money options must be designated fair
  value hedges.
• The accounting for both types of hedges for
  options is similar to their accounting for
  forward contracts.

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Comparison of Cash Flow and Fair Value Hedges

• There is no difference in the ultimate impact on
  income.
• A cash flow hedge distributes the financial
  effect of a hedge predictably evenly over its
  life. A fair value hedge distributes it
  according to changes in market value.
• Undesignated hedges are netted and reported in
  the same way as fair-value hedges.

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Foreign Currency Firm Commitments

• Although cash flow hedge accounting might be
  used, fair value hedge accounting is usual.
• Under fair value hedge accounting
• The gain or loss on the hedging instrument is
  recognized currently in net income.
• The gain or loss (that is, the change in fair
  value) on the firm commitment attributable to the
  hedged risk is also recognized currently in net
  income.
• This accounting treatment requires
• Measuring the fair value of the firm commitment
• Reporting the firm commitment on the balance
  sheet as an asset or liability.
• Recognizing the change in fair value in net income

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Measuring Firm Commitment

• The value of the firm commitment can be measured
  using either the spot rate or the forward rate to
  the date of execution.
• If the forward rate is used both to hedge and to
  measure the firm commitment, over the life of the
  contract, gains on one will always exactly offset
  losses on the other and the value of one will
  always be equal and opposite to the value of the
  other.

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Reporting Firm Commitment

• No entry records either the firm commitment or a
  forward contract because both are executory
  contracts. An option would be recorded as an
  asset at its purchase price
• A memorandum would be prepared to designate the
  derivative as a hedge of the risk of changes in
  the fair value of the firm commitment.

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Changes in Value of Firm Commitment

• Changes in the value of the firm commitment and
  the value of the hedging instrument are recorded
  on the income statement as gains or losses

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Forecasted Foreign Currency Transactions

• Unlike the accounting for a firm commitment,
  there is no recognition of the forecasted
  transaction or gains and losses on the forecasted
  transaction.
• The hedging instrument is reported at fair value,
  but because no gain or loss occurs on the
  forecasted transaction to offset changes in fair
  value, these changes are not reported as gains
  and losses in net income. They are reported in
  AOCI on the balance sheet.
• The original premium or discount, however, is
  amortized.
• On the projected date of the forecasted
  transaction, the balance in AOCI is transferred
  from the balance sheet to net income on the
  income statement.

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Forward Contract Example (Dell Hedges Forecasted
Foreign Cash Receipts)

• On 1 October 1992, Dells German subsidiary
  anticipates receiving DEM 36M from computer sales
  in 6 months on March 31, 1993. This amount will
  be converted into USD.
• Simultaneously, Dell makes a forward contract to
  sell DEM 36M in 6 months at a rate of 1.4448
  DEM/USD.
• The current spot rate is 1.4260 DEM/USD

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Rates and Values
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December 31
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December 31
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Quarterly Income Statement
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Balance Sheet
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March 31
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March 31
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March 31
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March 31
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March 31
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Quarterly Income Statement
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Balance Sheet
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Options Example (Dell Hedges Forecasted Foreign
Cash Receipts)

• The purchase of the option is recorded on balance
  sheet.
• Changes to the time value of the option are
  recorded on the balance sheet and the income
  statement.
• Changes to the intrinsic value of the option are
  deferred until the forecasted transaction occurs.

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Dells 2 August 1992 10-Q

• The results of the Companys international
  operations are subject to currency fluctuations.
  However, the Company attempts to reduce its
  exposure to currency fluctuations through the use
  of foreign currency option and forward exchange
  contracts for periods not exceeding twelve months
  which hedge certain anticipated shipments to
  foreign subsidiaries. Based upon foreign
  currency exchange rates at August 2, 1992, option
  contracts which hedge anticipated shipments to
  international subsidiaries had a combined net
  realized and unrealized loss of 38 million which
  will be recognized as a cost of the hedged
  transactions over the periods during which the
  anticipated shipments occur in fiscal years 1993
  and 1994.

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Clarification

• Realized Hedging instruments have matured and
  gains and losses are recorded in AOCI at their
  maturity value.
• Unrealized Hedging instruments have not matured
  and gains and losses are recorded in AOCI at
  their market value.
• Recognized The forecasted cash flow has occurred
  and the hedging gains and losses have been moved
  from AOCI to the income statement.

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What is the Problem?

• Dell claims it is hedging forecasted foreign
  currency cash receipts. Its AOCI is -38M, and
  this amount will eventually be netted against
  cash receipts which will be higher than forecast.
• Kidder Peabodys analyst David Korus claims that
  Dell is speculating. This -38M is a loss that
  should have been recognized on the income
  statement.

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Volume

• 1991 Annual Report (3 February 1991)
• 36M of foreign exchange contracts outstanding
• 1992 Annual Report (2 February 1992)
• 435M of written option contracts outstanding
• 45M of forward contracts outstanding
• Unknown value of purchased option contracts
  outstanding however, option position is
  described as cashless, that is, purchased puts
  are paid for with written calls.
• Expiration dates do not exceed one year

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Spot Rates and AOCI
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Scenario 1

• Dell was speculating with calendar spreads
  writing a series of short-dated calls but
  purchasing long-dated puts.
• As long as the exchange rate doesnt do anything
  unexpected, the premium income on 12 1-month
  calls, for example, should exceed the premium
  expense for 12-month puts.

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Illustration

• On 14 January, 1992, the spot rate was .6266
  USD/DEM
• The dollar was expected to rise slightly
• 30-day forward .6236
• 90-day forward .6185
• 180-day forward .6111
• 1-month (14 February) at-the-money calls (strike
  price .63) were selling for 500 per 62,500 DEM
  contract
• 5-month (12 June) at-the-money puts (strike price
  .63) were selling for 1,775 per 62,500 DEM
  contract.

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Scenario 2

• Dell was appropriately structuring its hedges, so
  they werent actually speculating.
• But the treasury department was being run as a
  profit center, in which case losses on hedges are
  to be avoided even if offset by gains on the
  underlying transactions.
• Dell was actually hedging with calendar spreads.

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Scenario 3

• Dell was using ratio spreads writing more calls
  than they were buying puts.
• If the dollar is expected to rise, as it was, X
  out-of-the-money puts will be worth more than X
  out-of-the-money calls.
• Puts with the same premiums as calls will be
  further out-of-the-money.
• Dell tried to preserve some of their upside
  potential by selling more calls that were further
  out-of-the-money

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If the USD falls unexpectedly

• The call options will show a loss.
• Dell can engage in frequent and hectic intra-day
  trading in an effort recoup some of its losses.
• Rather than a cash settlement, Dell can roll the
  call options over into new call options sold at a
  premium below their market value.
• Neither of these responses qualifies for hedge
  accounting.

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Financial Evidence I

• Dell has indicated that their puts and calls are
  struck at a 10 spread, that is, each is 5
  out-of-the-money.
• Historically, those call premiums would be half
  the put premiums.
• Dell is probably hedging forecasted European
  sales of around 200M. (European sales 1989-91
  were 38M, 71M, and 149)
• For a cashless hedge, Dell would need 200M of
  puts and 400M of calls.
• This is quite close to Dells reported 435M of
  written calls.

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Financial Evidence II
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Comparative Evidence
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Timing Evidence

• In March, Dell reported that it entered into a
  new complex option hedge position.
• On March 19, the SEC disallowed hedge accounting
  for complex option strategies or written foreign
  currency options.
• Were they trying to trade out of a loss before
  the rules changed?

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Personnel Evidence

• In May, Dell hired an experienced foreign
  exchange risk manager, after which foreign
  exchange activity seemed to increase
  substantially.
• In June, the CFO told investors that the
  financial picture was less clear.
• In September the foreign exchange risk manager
  and a currency analyst appeared to be let go, and
  the CFO resigned one day before the 10-Q was
  signed.

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Dells Testimony

• Dell denied engaging in calendar spreads or ratio
  spreads.
• Dell admitted speculating for a brief period of
  time and realized an immaterial net gain.
• Dells hedging resulted in an immaterial net
  gain.
• Dell has complied with all accounting rules, and
  all of its practices have been fully reviewed by
  its auditors.

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Other Testimony

• Bear Stearns We believe that there is no
  publicly available evidence that Dell has done
  anything improper.
• Derivatives Week Investment bankers have had no
  confidence that they understood what they were
  doing and declined to do business with Dell
  because they did not have confidence that the
  companys foreign exchange treasury officials
  were authorized to do the trades they tried to
  initiate.
• DLJ It is impossible to know the answer at this
  point.
• Dean Whitter There was a relatively small amount
  of speculative currency trading gains in the
  first nine months of the year speculative
  currency trading has since been stopped.

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What do YOU think?
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Dell Annual Report 1995

• During 1993, the Company entered into foreign
  currency forward and option contracts with the
  intent to profit from anticipated movements in
  exchange rates. The Company marked the contracts
  to market and recognized resulting gains and
  losses as a component of net financing and other
  income. Net foreign exchange losses recognized
  during 1993 consisted of 9.6 million in losses
  related to foreign currency trading activities
  and 9.0 million in foreign currency transaction
  gains associated with unhedged intercompany
  balances and other foreign currency transactions.
  The Company resumed its intercompany hedging
  practices in the third quarter of 1993. During
  1994 and 1995, the Company did not enter into
  foreign currency contracts with the intent to
  profit from movements in exchange rates.

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Dell Annual Report 1995

• On November 30, 1992, the SECs Division of
  Enforcement notified the Company about an
  informal inquiry regarding the Companys
  accounting practices for foreign currency hedging
  and trading activities and the completeness of
  the Companys public disclosure about those
  activities. The company and its independent
  accountants are voluntarily cooperating with the
  SEC in this informal inquiry. The SECs Division
  of Corporation Finance has also indicated it has
  concerns about the deferred accounting treatment
  the Company afforded gains and losses on the
  forward and option contracts entered into to
  hedge anticipated transactions and has not
  expressed its definitive views about whether the
  Companys accounting for these forward and option
  contracts complies with generally accepted
  accounting principles in all material respects.
  The Company has not received correspondence from
  the SEC regarding this matter since September
  1993.

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