Chapter 4: FOREIGN EXCHANGE BASICS

CHAPTER 4

Foreign Exchange Basics

IN INTERNATIONAL COMMERCE , 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.

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.

Hedging

The management of currency in international transactions is often accomplished through hedging. A hedge is a contract that provides protection against the risk of loss from a change in foreign exchange rates. There are three common methods of hedging.

1. FORWARD MARKET HEDGE A trader can lock in the rate at which he can buy or sell a foreign currency by buying, at the time the original sale of merchandise (or services) agreement is made, a forward contract to sell or buy that currency with delivery set at the anticipated payment or receipt date.

2. MONEY MARKET HEDGE A trader can reverse a future foreign currency payment or receivable by borrowing domestic currency now, converting the currency into foreign currency at today’s exchange rate, and investing the proceeds in foreign money market instruments. The proceeds of the money market instruments upon maturity can be used to meet the foreign currency needs payable at that date.

3. OPTIONS MARKET There are two types of foreign currency options available to manage risk. A

“put” option gives the buyer the right, but not the obligation, to sell a specified number of foreign currency units to the option seller at a fixed dollar price, up to the option’s expiration date. A “call” option, on the other hand, is the right, but not the obligation, to buy the foreign currency at a specified dollar price, at any time up to the expiration date.

RISKS OF HEDGING While hedging can reduce a trader’s exposure to foreign currency fluctuations, the costs of such instruments must be balanced against the risk of loss. Their usefulness is also limited by the fact that they are only available for major currencies and for certain maturities, which makes their use difficult for traders with substantial exposure in developing countries. However, since most trade is conducted in the major currencies for which options are available, and many international payment terms are consistent with the maturity terms of currency hedging instruments, they are usually a viable alternative.

COSTS OF HEDGING For a trader that has frequent exposure in many currencies, hedging every transaction is counterproductive, since the likely outcome of the gains and losses under an unhedged position will approach zero. Unless the exchange market is perceived to be grossly distorted due to undue government intervention or some other reason, a policy to hedge all exposures is likely to be as costly as the expected exchange rate changes. If hedging a large number of transactions will produce the same outcome as the unhedged position, then the overall gain from hedging operations is slightly negative because of the cost of arranging the protection.

HEDGING RISKS FOR BUYERS Since most traders prefer to avoid the risk of currency fluctuations, they usually shift the foreign exchange risk to commercial banks. If a buyer arranges to establish a letter of credit in the seller’s country, the payment to such seller will be made in the seller’s own currency by a designated overseas paying bank in the seller’s country. Upon receiving the documents from the opening bank in the buyer’s country, the buyer is required to supply domestic currency equal to the amount of foreign currency paid by the overseas bank. If the conversion of currency occurs on the same day as payment is made, it is usually based on the exchange rates of the two currencies on that day. The buyer’s bank just sells the foreign exchange to the buyer at that day’s rate—called the spot rate—and credits the foreign exchange account of the overseas bank. However, if the buyer wishes to eliminate any unfavorable exchange risk arising from currency fluctuations between the time the buyer arranges to open the credit and the date of actual payment, the buyer can arrange with the domestic bank at the time the letter of credit is opened to execute a forward exchange contract. Thus, the buyer knows the exact cost in dollars in time for the actual payment, and any exchange risk is assumed by its bank. In general, banks are better positioned to assume such risk as many have active foreign exchange management departments.

HEDGING HINTS FOR SELLERS If a seller receives a letter of credit in a foreign currency the seller may arrange with the local advising bank to sell the foreign currency to be realized upon payment. In this case, the risk of exchange is assumed by the seller, since the conversion of foreign currency into local currency will be made at the rate of exchange on the day the seller executes the exchange contract with its bank. To avoid any risk of foreign currency devaluation on the date of transaction, the seller should consider borrowing the same foreign currency for the duration of the outstanding transaction and selling the loan proceeds at the current rate for the local currency. At the time of payment by the foreign bank, receipt of foreign currency will repay the borrowing. By immediately selling the loan proceeds at the outset for domestic currency and placing them on time deposit, the ensuring interest yield will reduce the gross borrowing expense.