Foreign Exchange Risk Mitigation Techniques/Business Needs for Foreign Currency

Unit 2.1-Foreign Exchange Risk Mitigation Techniques

Return to Trade Finance Module 2: Risk Mitigation Techniques

Business Needs for Foreign Currency

Accounts Payable and Accounts Receivable

Companies purchase raw materials or component parts for the manufacturing of goods. When the transaction is conducted in a currency other than the local currency, risk increases. In order to control the cost of goods sold and reduce the risk, using some form of hedge is necessary.

Companies that buy and sell in a foreign currency will often use a netting effect. The company will maintain a foreign currency account to deposit funds from sales and to withdraw funds to pay for purchases. The repatriation of funds generally results in the form of profits which are converted and transferred to the home office periodically, thus taking advantage of favorable market conditions.

Interest rates vary widely from country to country. It often makes sense, depending on the cash position of the company, to take an equal and opposite foreign exchange exposure position to complete a transaction at maturity. The company could take out a loan in the amount of a receivable in the foreign currency, convert it to their local currency and use the proceeds from their receivable to pay off their loan. The company may also buy the foreign currency and place it on deposit with a bank to earn interest and use it to pay off the payable at maturity. This action will enable the company to fix the exchange rate and take advantage of favorable investment opportunities.

A buyer and seller may agree contractually to share the exposure risk. They can establish different parameters based on market conditions to control the risk. Parameters can include payment of goods in the local currency, the splitting of the payment in both the buyer’s and seller’s currency, or the inclusion of a price adjustment clause if the exchange rate changes substantially.

The most common means to control exposure risk is to engage in a forward contract either in the form of a purchase or sale of a currency. The forward contract establishes a fixed price to be paid at maturity on the date the contract is executed. The general requirement is a small security deposit to secure the completion of the trade at maturity. Thus the company fixes the price without using capital until the maturity of the contract. The fixing of the price of the foreign exchange contract also allows the company to make a decision today whether to proceed or not based on current rates. The company can then price the product for sale based on the actual cost of the components.

Balance Sheet Hedging

Foreign currency options protect against adverse foreign exchange fluctuations while benefiting from a positive movement in the exchange rate. The trader is provided with the right but not the obligation to buy (call option) or sell (put option) a specific amount of foreign currency at a fixed price within a set period. Protection is provided. If the rates are unfavorable to the trader, he will just exercise the option; should the rates be favorable to the trader, then there is no need to exercise the option. Because of its advantages, this process for a right to buy or sell can be expensive. It is generally used for large denominations. Contingent obligations resulting from long contract negotiations could make this an attractive means of controlling exposure risk.

Acquisition Activity

Acquisitions take time to conclude and are often in large denominations. The evaluation of an acquisition is difficult enough without the worry of foreign exchange rate fluctuations. Options provide a good hedge against rate fluctuations during the negotiation process.

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