Foreign Exchange Management: A Key Concern as Turbulence Hits European Currency Markets
Many of our readers involved in international business have asked us how the recent turbulence in the European currency markets will impact their company's ability to export products. Peter Wadkins, a senior vice president at MTB Bank in New York, discusses how these events will affect international business.
Peter Wadkins: It will be more difficult for companies to price their products. The recent widening of the currency bands within the European Rate Mechanism (ERM) has increased the potential for greater currency volatility, as the currencies will now be allowed to fluctuate by 15 percent within the ERM bands, rather than the 2.25 percent that was in place. Economic dislocations amongst member countries and the realignment of the currency bands means that the unified market approach has been postponed. U.S. companies will have to continue to manage exposures against individual currencies for a longer period of time than had been originally planned.
Business Credit: Since the European currencies (other than the Dutch guilder) have widened their bands, do you have any specific forecasts for these currencies?
PW: As the French franc is the strongest of the ERM currencies (other than the German deutsche mark) we tend to focus our attention on how that currency will fare against the Deutsche mark (DM).
Presently, the French franc has weakened about 4 percent since the realignment. The franc is currently around 3.51 per DM, and a gradual weakening to around 3.60 against the DM over the next six months, or an additional 2 percent is expected. The other currencies should fare similarly (the width of the bands makes it hard to speculate against them), but in general, we should see the Spanish peseta and Danish krone get hit the hardest, with perhaps a further 5 percent depreciation from current levels against the DM.
BC: And against the U.S. dollar?
PW: We are bullish on the U.S. dollar, despite the difficult time that the current Administration has experienced pushing its economic programs through. U.S. exporters are extremely competitive at these levels of exchange rates, and as Latin America seems to be drawing closer to the U.S., our exports are booming in that part of the world. It is our belief that the dollar is on a cyclical upswing which started in September 1992, and that although it may see bouts of weakness, it presents buying opportunities. Exporters should look for the dips in the exchange rate to cover their currency receivables.
BC: Some U.S. companies avoid getting involved in currency billing because they feel it is safer to conduct business in dollars. They feel that they can still compete with the Europeans without indulging in what they view as currency speculation. How do you feel about this?
PW: This strategy was somewhat successful while the dollar was falling between 1985 and 1992. Companies billed in dollars, and the dollar fell against the European currencies, so products dropped in price against local competition. The dollar has since reached a cyclical bottom (September 1992) and then strengthened between 20-40 percent against various European currencies. U.S. goods have increased in cost to the overseas buyers without any benefit to the U.S. exporters' bottom line.
BC: So the strength of the dollar should be impacting the sales volumes of our exporters?
PW: Exactly. Just because you bill in dollars your goods are not isolated from currency movements. When billing in dollars, the onus is on your overseas customer to manage the exchange risk. At best, the overseas customer will demand some sort of discount (around 10 percent) compared with his other suppliers to offset the additional business risks. At worst, dollar billing will cause overpricing compared with local suppliers (or other European suppliers) and business will be lost. By billing in local currency, you can take control of your products' costs and factor in the cost of currency hedging when providing costs to your clients.
BC: If a U.S. exporter was to switch to currency billing, how would he manage the currency risks? What tools are available in the market place to hedge?
PW: There are primarily three alternative markets: cash, futures, or options. Cash markets are more flexible because they give you a variety of maturity dates, amounts, and currencies. Futures markets use set amounts, set delivery dates, and don't cover as many currencies. There are both over the counter (OTCs) and exchange traded options (ETOs). OTCs can be tailored to your individual requirements; EOTs are standardized, like futures.
BC: What exactly is the difference between them?
PW: Foreign exchange contracts in the "cash" markets are a direct obligation on the company to deliver currency in exchange for dollars (or another currency, if so desired). The value date, or maturity date of the contract, can be any time from two days from today to as much as five years, in some currencies. The amount is matched with the exporter's requirement; the delivery date is also matched to the anticipated time of the requirement. If the exporter discovers that there will be a payment delay, the forward contract is rolled over to meet his requirement. Alternatively, the exporter can enter a forward contract that has an optional delivery date.
Say, for instance, that the exporter is expecting payment in mid-December, he can enter a contract to sell currency forward any time between Dec. 1 and Dec. 31, if he is confident that his overseas buyer will pay within two weeks of the agreed date. Futures have set delivery dates, normally around the 15th of the month, for each quarter: March, June, September, December. The amounts are standard, DM 125,000, STG 62,500, yen 12,500,000. The customer has to put margin up against the contract, which is marked to market daily. The futures contract is an obligation that has to be met, and the customer can deliver currency against it when it matures.
Options give the customer the right, but not the obligation to deliver currency at an agreed future "strike price." The "option" is to exercise at that strike price or allow the option to expire unexercised. If it is an over-the-counter option, the amount can be tailored to the customer's individual requirement, but OTC options are not normally available in small amounts. If it is an exchange traded option, the amounts (which vary with each different exchange) and the strike dates (deliver dates) are standard--around the 15th of the month in March, June, September, December. The customer has to pay the bank or the futures exchange a premium up front which gives the customer the right to exercise the option at the strike price or to allow the option to lapse unexercised. This allows the customer to benefit from positive exchange movements; the other two choices don't. It also provides coverage in the event the market moves against the customer. The downside is that options are expensive in the current volatile markets.
BC: What advice would you give to someone just getting involved with currency billing?
PW: Small- to medium-sized companies probably don't have the time to monitor the currency movements therefore, futures probably won't work. Speak to your local bank, and if they can't help you, get in touch with someone who can provide the advice and guidance you need.
I would think that "cash" markets would be preferable to options, unless management has a comprehensive knowledge of how options are priced and how they work. Most growth companies with which we speak use forward contracts to hedge their receivables and find it easier to match everything up. MTB also helps them by monitoring their interests in the market on a 24-hour basis, which provides them coverage against adverse developments.
BC: How do exchange rate movements impact importers?
PW: Importers that pay in dollars normally only get affected when the dollar declines, in that they have to pay more dollars for the same product. Between 1985 and 1992, U.S. importers got beaten up, particularly last year when the dollar hit all-time lows. Right now, they should be benefitting from the dollar's strength against the European currencies, although Japanese imports are very expensive, given that the yen's all-time high was just reached. Unfortunately, overseas exporters are normally slow to respond to changes in exchange rate values which fatten their profit margins and will wait a while before they pass any benefit back to the U.S. importer. Furthermore, foreign partners will add a surcharge of approximately 10 percent as they are bearing the exchange risk.
BC: How can American companies make sure they get a fair price?
PW: Check with your bank. Find where the exchange rates are at the time of purchase and compare the U.S. dollar pricing with local currency pricing, which shows you what margin the exporter is charging for bearing the exchange risk. If they are charging too much for covering the exchange risk, a business can try to get them to improve the terms. Alternatively, a better choice would be to start purchasing in foreign currency and take control of your input costs up front.
BC: Many importers think that this would be speculating. Are you suggesting that they gamble on exchange rates?
PW: No, we are telling our clients that currency exchange is simply another input cost that has to be borne by the importer. If a business knows what it's being charged in local currency, it can hedge the purchase cost with a local bank. If not hedging one specific order, but anticipating several months of orders, select a percentage of sales that the business is confident that it will do as a minimum, say 25 percent, and purchase sufficient currency to cover that. If the currency strengthens against the dollar, you have locked in the price for 25 percent of your inventory. If the currency weakens against the dollar, there is still a further 75 percent of your sales to hedge. If you get a favorable exchange rate move which affords bigger margins, lock some of it in. If you have a specific sales contract and you want to lock in the costs, cover the whole thing.
BC: So what you are advocating is that companies take a more active role in managing their costs, and that foreign currency exchange is simply another cost to be managed if handled correctly?
Questia, a part of Gale, Cengage Learning. www.questia.com
Publication information: Article title: Foreign Exchange Management: A Key Concern as Turbulence Hits European Currency Markets. Contributors: Not available. Magazine title: Business Credit. Volume: 95. Issue: 10 Publication date: November-December 1993. Page number: 18+. © 1999 National Association of Credit Management. COPYRIGHT 1993 Gale Group.
This material is protected by copyright and, with the exception of fair use, may not be further copied, distributed or transmitted in any form or by any means.