During the past year, the value of the U.S. dollar has changed fairly dramatically in terms of many other currencies. For example, the dollar fell about 10 percent in value against the Japanese yen in March 2004 alone. From September to November of 2004, the dollar’s ongoing fall against the euro grew by another 10 percent. If you consider an even longer period of time, the changes can be even more dramatic. It’s not unusual for the change to be in excess of 30 percent if the time horizon stretches to a year or more. It becomes obvious that this sort of short-term change in exchange rates can present a very difficult challenge to managers who routinely operate in a global context as they strive to remain price competitive while maintaining satisfactory profit margins. While this is a formidable challenge to any firm, it seems even more daunting to a small firm, especially if it is a newcomer to international trade.
Let’s examine a hypothetical example of the potential impact of this exchange rate variability phenomenon. Let’s assume that at the beginning of 2004, a small European manufacturer of automobile components priced its best selling product to its U.S. based customers at 150 euros. At an exchange rate of €1 (euro) = $1.10 (U.S.), the price in dollars to the U.S. dealers was $165, the same price as a comparable component produced and sold by a U.S. based competitor. By December of 2004, the exchange rate had changed to €1 = $1.34. If the manufacturer wanted to maintain a stable profit margin, it would continue to sell its product for €150 euros. The problem is that this sales price would then translate into a U.S. price of $201. This is a price increase of almost 22 percent in less than a year! The European manufacturer’s now uncompetitive price was not caused by poor management. Instead, it is a function of a variable (exchange rates) that is not controllable by the manufacturer’s managers. Imagine the additional competitive pain that could be inflicted by an aggressive U.S. based manufacturer that decides to reduce its prices in the U.S. market while its European competitor’s price is increasing!
The Initial Problem
When a firm sells to foreign customers, either the firm or its buyers are subject to the exchange rate risk inherent in such transactions. The sales/marketing side of the firm is primarily concerned with facilitating these transactions by doing everything in its power to make the buyer happy with its overall offering, while the treasury/finance side of the firm is primarily concerned with minimizing the financial risk inherent in such transactions. As managers of large global firms know, the natural tension that such sales create between the marketing and treasury functions of a firm can cause considerable dysfunction.
The seller must make a choice about the currency in which it will invoice its customers. The natural tendency for a manager focusing on the financial implications of the transaction is to prefer that the invoicing be in the firm’s domestic currency, thereby passing all of the transaction’s exchange rate risk along to the buyer. However, the sales/marketing-oriented managers in the selling firm want the potential buyer to be happy. They know that the buyer will be happier if the seller agrees to assume the exchange rate risk by invoicing the transaction in the buyer’s domestic currency. The seller’s marketing manager will claim that her firm’s agreement to absorb this risk is a “market friendly” gesture. The seller’s finance department will likely have little concern about this risk if it is short-term in nature, since short-term exchange rate risks can be addressed in three short steps.
Step 1: Identify the Exposure
A financially sophisticated seller will likely use one of three major types of risk management products to hedge currency exposures, depending on the size and frequency of the foreign exchange transactions. These risk management practices include forwards, options, and swaps. Before entering into any particular type of contract, however, the seller must consider its net exposure to the foreign currency. Net exposure is the degree to which a firm is net long (or positive) or net short (or negative) in a given currency (FX):
Net exposure = Net foreign assets – net FX bought
Going back to our prior automobile components example, suppose we have a U.S. manufacturer that sells components on credit to a customer in a country in which the euro is the transaction currency. If we assume the U.S. price is $150, then we have a net exposure in U.S. dollars of $150 per unit. If the exchange rate is €1 = $1.30, then the euro equivalent is €115.38. This is the exposure in euros that must be hedged.
Step 2: Choose a Hedging Instrument
The risks associated with collecting in a non-dollar-denominated currency can be enormous. Fortunately, forwards, swaps, and options can help to mitigate these risks.
Forward transactions provide a way of eliminating exchange rate risk when a firm is to receive or make a foreign currency payment in the future. A forward transaction enables one to buy or sell a currency at a fixed rate at some specified date in the future. By aligning this date to the date of the foreign currency payment, one essentially locks in the exchange rate and eliminates the risk of future fluctuations of that currency. Banks typically offer short- and long-dated forwards in a variety of currencies to meet such demands.
The function of the forward FX contract is to offset the uncertainty of the future spot rate (the then prevailing exchange rate) on a foreign currency at the end of the investment horizon. Once again, using the foreign automobile components sale as an example, we suggest that instead of waiting until payment is received to transfer foreign currency back into dollars at an unknown rate, one can enter into a contract to sell forward the sales amount, at the current known forward exchange rate for dollars/foreign currency. The delivery of the foreign currency to the buyer occurs at the end of the investment horizon. This activity essentially removes the future spot exchange rate uncertainty. The following example illustrates this strategy.
On January 1, 2005, a U.S. based automobile component manufacturer sells 100 components at $150 each, for a total of $15,000, on credit and wants to hedge the risk exposure of collecting and converting €11,538.46 back to U.S. dollars. Assuming the credit period is one year, one would enter into a forward agreement to sell €11,538.46 for $15,000 on January 1, 2006 to hedge this transaction. One would thus effectively eliminate the currency risk associated with the foreign transaction. Regardless of what happens to the exchange rate, the seller is guaranteed to receive $15,000.
Advantage: Can lock in exchange rate, which guarantees a particular future payment.
Disadvantage: Gives up translation profit if euro currency appreciates against the U.S. dollar and creates transaction costs of forward contract.
Options are contracts that, for a fee, guarantee a worst case exchange rate for the future purchase of one currency for another. Unlike a forward contract, the option does not obligate the buyer to take delivery of a currency on the settlement date unless she exercises the option. Foreign exchange options thus protect one against unfavorable currency movements while allowing participation in favorable movements. Therefore, the mechanics of options contracts are such that one would pay a premium similar to that of an insurance policy in order to protect against adverse price movements.
Advantage: Options protect against downside risk and allow upside appreciation.
Disadvantage: Options are essentially an insurance policy and therefore can be quite costly.
Currency swaps represent a way for a corporation with recurring cash flows in a foreign currency or one seeking financing in a foreign country to eliminate exchange rate risk. In a currency swap, one simultaneously purchases and sells a given currency at a fixed exchange rate and then exchanges those currencies at a future date. This maneuver allows one to convert a stream of cash flows in one currency into another currency at a fixed exchange rate. This technique in effect creates an on-balance sheet liability that must be settled in the future. One concern with currency swaps is that of counterparty credit risk when the time comes to settle the transaction. For this reason, many contracts only exchange the netted cash flows at pre-specified time intervals. This practice in effect is a credit risk mitigating strategy.
Advantage: Currency swaps protect against exchange rate fluctuations.
Disadvantage: Currency swaps give up translation profits and can be subject to counterparty default risk.
Step 3: Hedge the exposure
Once the seller has evaluated the appropriateness of these financial management products, he can decide on the best way to hedge the currency risk exposure. Most often, currency translation exposures are mitigated through the use of forward contracts or a standardized version of forwards—futures contracts, which are traded on organized exchanges.
What if it’s not that simple?
The rub comes when the rate of exchange between currencies is in a long-term trend in a particular direction, and the seller might want to be market friendly by extending lengthy credit terms to its buyer (e.g., three to five years). It becomes difficult (if not impossible) and/or costly to attempt to address this sort of long-term exchange rate risk. Under this scenario of limited ability on the part of the seller to address concerns related to exchange rate risk, how should managers proceed if they desire to be “market friendly” in this way?
One must first recognize that there are circumstances under which a buyer might have little choice but to be “market friendly.” For example, in a recent visit to a small manufacturing concern in the Czech Republic, one of the authors inquired as to the invoicing practices of this Czech firm. Without hesitation, the two senior managers indicated that their economically powerful customers simply forced the seller to invoice in the buyer’s currency. The seller was so dependent on its large buyers for its very survival that it had no choice but to assume the exchange rate risk. In the case of this Czech firm, it has little concern about such a practice since its large customers tend to be domiciled in countries whose currencies are fairly stable against the Czech krona. However, as the Czech Republic transitions to use of the euro over the next several years, this situation may well change. What should a small firm do when dealing with large, powerful customers who can dictate the terms of their transactions?
One option is to attempt to develop a large and diverse enough customer base to allow existence of a “natural” hedge against exchange rate fluctuations. For example, if the small firm has customers in the U.S., the E.U., Japan, etc., it is likely, although not a certainty, that over time the fluctuations of the various currencies of this diverse customer group will offset each other. This sort of hedge is fairly common in today’s global environment for very large firms that do business on a truly global basis. However, the likelihood is low that smaller firms can consistently and effectively protect against currency fluctuations in this manner.
A second, less familiar form of risk reduction for small firms would be to utilize various forms of countertrade (modern variants of barter) in conducting their global transactions. The basic idea under this approach would be that payments for products sold would be received in the form of other products rather than in the form of foreign currencies. Since the value of a product might be far less volatile than the value of currencies, the risk of fluctuations in product value should be greatly reduced.
A Hypothetical Example
Let’s again look at a hypothetical example. Suppose that a small manufacturer of automotive components is confronted with currency fluctuations of the magnitude that have been illustrated above. In such a competitive industry, profit margins tend to be quite small, and the large automobile assemblers, such as Toyota, consistently apply pressure for even lower prices (and, therefore, lower margins) on the components they outsource. If the small manufacturer experiences a 20 percent increase in the value of its domestic currency vis-à-vis the Japanese yen (in the case of Toyota) and is unable to pass along the currency swing by increasing its prices to its Japanese customers, it will find itself losing money on each part it sells to that customer. However, if the small manufacturer can work with its customer, one of its subsidiaries, or a third party in Japan that has a product that the manufacturer could use in its own production or operations or that it could effectively resell to another party, the potential exists that the 20 percent change in the value of the manufacturer’s domestic currency would not impact the net price of the component parts that the manufacturer is selling to the Japanese customer.
This sort of approach to dealing with the pricing challenges that arise when currency fluctuations are of a significant magnitude is in itself a challenge. Such an approach requires the cooperation of the marketing/sales and treasury/finance functions in an organization. Depending on the complexity of the arrangement that needs to be structured, this approach might also require the involvement and/or agreement of other functional areas of business such as procurement, production, and operations. However, when viewed in the context of the alternative (that is, abandoning customers in markets whose currencies have significantly depreciated), the challenges inherent in using this non-traditional approach to being market friendly might seem to be very worthwhile.