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A case in point comes from a private label
food-processing company in the Buffalo area. For the past 18 years this
company has been exporting a significant portion of its product to Canadian
customers. The business would receive the mailed checks in the United States
but were payable in Canadian dollars. Once the company received and
accumulated enough checks, it would drive once a week across the border, to
deposit these checks into a Canadian bank account. Both inconvenient and
risky, this company faced foreign exchange risk with currency volatility due
to the lag time from mail delivery which usually took 7-10 business days.
Several months ago, the company learned about
foreign-exchange tools and strategies offered by its bank. They now work
with their bank to accept checks into a Canadian lockbox, which allows them
to convert the Canadian currency to U.S. dollars at any point in time. In
addition, the company has developed a hedging strategy to protect its profit
margins for their yearly Canadian sales. This company has improved its
competitive position by becoming more efficient with cash flow, and reduced
its currency risk exposure which has saved the company thousands of dollars
per year.
What is foreign exchange risk?
Foreign exchange fluidity can have an impact on large enterprises and small
companies alike.
Any company that trades in an overseas market,
importing or exporting goods or services, subjects itself to currency
fluctuations that occur between a purchase order and payment.
The Buffalo company was trying to avoid foreign
exchange risk by doing business only in U.S. dollars. However, firms do not
escape foreign exchange risk simply by conducting business in the home
currency.
Businesses that invoice only in dollars often put
themselves at a competitive disadvantage and would be better off offering
local currency prices and managing the risk with various hedge tools and
strategies.
Fortunately, there are exchange tools that can help
minimize risk, for example:
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Spot contracts, the most basic and popular foreign
exchange product. It is an agreement to buy or sell one currency in
exchange for another. You settle the contract the same day, at a price
based on the prevailing “spot exchange rate” – the current value of one
currency compared to another. Spot contracts eliminate concerns about
currencies price shifts between the time a company pays in dollars and
the foreign company receives payment in its currency.
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Forward contracts further eliminate the risk of
fluctuating exchange rates by locking in a price today for a transaction
that will take place in the future. This is called hedging, or insuring,
your expected foreign currency transactions. You can sign a forward
contract with a bank today giving you the right and the obligation to
buy dollars in three months time at a rate agreed today (the forward
rate). This removes the currency risk by fixing the exchange rate in
advance. Forwards negotiated with a bank can be tailored to the exact
needs of the company in terms of amount and maturity date.
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Foreign currency options give you the right (the
option) to buy or sell a specific amount of currency against another at
a predetermined price within a specific period of time. You have the
option – but not the obligation – to exercise the contract (for example,
you can simply let the option expire without exercising it). The seller
of the option, however, has no choice: it has to sell or buy the option
if you exercise it. Like a forward contract, a foreign currency option
eliminates the spot market risk for future transactions. But unlike a
forward contract, it does not force you to do the deal if the spot rate
is more favorable than your prearranged exchange rate.
The foreign exchange market and global economic climate
can be volatile and uncertain. But there’s one thing you can be certain of –
unfavorable exchange rates can be very destabilizing to a business. That’s
why it pays to take advantage of the tools that will help you manage your
exposure to foreign exchange.
John Riley is Vice President of Currency Risk
Management at Citizens Bank and works with clients in Buffalo and throughout
New York.
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