CHAPTER 4
Foreign Exchange Basics IN
C O M M E R C E , payment for goods and services usually involves the currencies of more than one country, and the problem of which currency to use can become a serious barrier to completing a deal. There would be no problem if the currency of a seller’s country could always be bought and sold at a fixed and invariable price compared to the money of a buyer’s country. However, in most cases, the relative value of currencies is constantly changing, and some are quite volatile. If the value of a currency changes between the time a deal is made and the time payment is made it could have a serious impact on the profitability of a transaction. For example, if a trader has made a deal to be paid in a foreign currency and that currency devalues before payment is made, the trader will receive less value for the goods than originally anticipated. Of course it is also true that extra profits could be made if the foreign currency increases in value. In any event, this is a risk most traders would prefer to avoid. There are many ways of dealing with foreign exchange risk and the simplest, if you are the seller, is insisting on payment in your own currency. This strategy lays the risk at the buyer’s door, but it may not always be a viable option, and traders may have to accept payment in foreign currency in order to make a sale. If full agreement cannot be reached, it may be possible for both buyer and seller to share the risk by arranging for a portion of the payment to be made in one currency and the remainder in another. If it is absolutely necessary to take on the foreign exchange risk, traders can protect themselves in a number of ways. One way is to build the estimated cost of a currency fluctuation into the deal to guard against potential losses. However, as this is simply an estimate it will rarely fully protect the trader.
INTERNATIONAL
Using a Third Country Currency While banks will undertake to assume the risk of currency fluctuations under foreign currency letters of credit, they do charge fees for this service (which can be hefty, especially if a company conducts many smaller foreign trade transactions). Since it is unlikely that either buyer or seller will agree to assume the risk of currency fluctuations, many international trade transactions are invoiced in a strong and stable currency—even if it is that of a third country. For this reason the US dollar (US$), the European euro (€) and the Japanese yen (¥) are all widely used in international payments. In fact, more than half of world trade is denominated in US dollars, although the Japanese yen is widely used for trade throughout the Pacific Rim. The euro is making inroads against both.
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