Currency tools help firms compete globally

As our world becomes ever more connected, U.S. companies increasingly are conducting business overseas. As a result, some 80 percent of all companies – both large and small – are exposed to foreign exchange risk. In addition, the use of financial tools to reduce this risk has grown in importance. Whereas such tools once were simply a method of making international transactions more convenient, today they are becoming a necessary method of remaining competitive in our global economy.

That is why it is important to understand what foreign exchange risk is, along with the tools available to mitigate it.

A recent example from a food-processing company in Manchester helps to explain this risk. For the past 17 years, the company has been importing food-processing machinery for its customers from Denmark. The company paid in U.S. dollars via wire transfer at a U.S. bank, which then sent the money to a Danish bank. The Danish bank then converted the dollars to Danish kroner several days later, and the Danish exporter received any advantage in the currency exchange.

Thus, whenever the kroner rose against the dollar, the Manchester company ended up paying far more money than was necessary and reducing its profit margin.

But several months ago, the Manchester company learned about foreign-exchange tools and strategies offered by its bank. The company now works with its bank to pay directly in foreign currency – and no longer passively accepts currency market risks. What’s more, the company realized that the savings in transaction fees and currency fluctuation enabled it to save about 1 percent per transaction – to the tune of tens of thousands of dollars per year.

What risk?

Foreign exchange exposure can come in many guises and 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, regularly subjects itself to currency fluctuations that occur between the time an order is placed and when the invoice is paid. Foreign exchange volatility is not something new, but its impact on both small and large businesses is gaining greater relevance.

The Manchester company was like most U.S. companies in that it was trying to avoid foreign exchange risk by doing business only in 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, including:

• 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. It eliminates worries about whether currencies will shift between the time a company pays in dollars and the foreign company receives payment in its currency.

• 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.

• 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, vice president of currency risk management at Citizens Bank, works with clients in New Hampshire and throughout the Northeast.