Identifying Foreign Exchange Risks in International Trade

Article excerpt

American companies marketing products and services overseas are finding that it improves their competitive edge to be able to quote prices and accept payments in foreign currencies. Selling in the customer's currency may put a U.S. supplier on equal footing with local and sophisticated multinational competitors and help keep prices from fluctuating. Selling overseas introduces two categories of risk beyond problems resulting from governmental interference in international transactions whether in U.S. dollars or foreign currency. Exchange rate risk occurs when sales are denominated in currencies other than the seller's. What will the currency be worth when it is received and converted into dollars?

Governments can affect the local exchange market by restricting access to foreign currency, limiting the forward market, and limiting international payments to certain types of transactions. This is commonly known as convertibility risk and can be difficult to control. Credit managers must gauge the impact of current restrictions and the probability of new ones being imposed. Among the questions to ask are:

* What restrictions does the country have?

* What impact have previous government policies had?

* Is the country liberalizing exchange and payment restrictions?

While most industrial countries have few restrictions, in times of crisis such as the one experienced by the European Rate Mechanism (ERM) last year, temporary illiquidity and official restrictions can occur in the exchange markets, causing difficulty in effecting payments and entering into foreign exchange hedge contracts.

Forward Contracts Keep Cash Flowing

The risk of adverse rate movements on non-U.S. dollar receivables or payables is a type of transaction risk which can be hedged using forward foreign exchange or foreign currency option contracts. A forward contract is a mutually binding agreement between two parties to exchange a certain amount of one currency for a specific amount of another currency at a date or range of dates in the future. Forward contracts offer the benefit of locking in known cash flows on future transactions.

Foreign currency options provide the protection of a "worst case" rate, while allowing the option holder to benefit from market movements in their favor. In exchange for the right, but not the obligation, to buy or sell the underlying currency at a pre-agreed price (strike price), the option holder pays a premium. Premiums vary depending on the length of time covered, market volatility, and strike price chosen.

When a company enters into a foreign exchange forward contract, it may actually amplify the potential worst-case loss it could incur if the foreign customer defaults on their purchase agreement. If the customer fails to pay or if the overseas sale does not occur as planned, the U.S. exporter is left with an "open" foreign exchange position. A foreign exchange contract obligates the exporter to deliver the agreed-upon amount of foreign currency to the bank in exchange for dollars. If its customer does not pay, the U.S. company must still deliver the foreign currency to their counterparty bank at the contracted rate, or extend (swap out) their foreign exchange forward contract if they expect to eventually receive the funds. If the exporter has no anticipation of receiving payment from the customer, they must buy the currency in the open market at a rate that may be more expensive than the dollars they will received under the original contract. Foreign exchange rates could also move in the company's favor, resulting in a gain when it closes out its forward contract. The impact of potential exchange market fluctuations can be assigned a percentage risk factor based on the historic volatility of the currency and the terms of the sale. …