Foreign Exchange Rate Risk; Currency Risk; FX Related Risk

One of the uncertainties of international trade involves fluctuating exchange rates. The fluctuating value of the currency can affect the payment performance of international customers. Currency exchange rates are influenced by a variety of factors including supply and demand; interest rate differentials; economic news; political events; and government intervention and there is no single entity that regulates or controls the foreign exchange market.  Currency movements are of particular concern in emerging markets, where it is difficult to offset exchange rate risk. Emerging markets often have trade deficits that can lead to sudden or frequent devaluation of the currency.

In export transactions, buyers and sellers rarely use the same currency, and the relative value of currencies is constantly changing. Foreign exchange or foreign currency translation is the process of expressing amounts in one currency in terms of a second currency.  One of the decisions faced by U.S. exporters will be whether or not to demand payment in U.S. dollars. Depending on whether the sale is denominated in the buyer's currency or the seller's currency, the buyer or the seller may incur additional costs (or lost profits) if the relative value of the two currencies change between the time the goods are sold and the time the goods are paid for. For this reason, a decision to accept payment in a foreign currency can harm the seller's profit margin.  It is possible to be paid in a foreign currency and offset some or all of the foreign exchange risks by purchasing contracts through banks or other financial institutions that allow the seller to "hedge" against foreign exchange fluctuations.

Foreign exchange rate fluctuation is one of the risks of selling internationally. Some companies expect their credit manager to both monitor and manage this type of risk. Currency exchange rates are influenced by a variety of factors including supply and demand; interest rate differentials; economic news; political events; and government intervention and there is no single entity that regulates or controls the foreign exchange market.

Foreign exchange risk relates to uncertainty about changes in foreign exchange rates that can adversely affect the amount of money a seller receives.  Here is an example:  A creditor company sells goods to a foreign company.  The invoice is denominated in the foreign customer’s local currency.  The seller ships the goods today, but will not receive payment for two months. During this 60 day period, the exchange rate fluctuates. When the foreign buyer pays the domestic company for the goods, the exchange rate at the time has changed to the point that the seller receive a lower than expected profit on the sale.

Converability refers to the ease or difficulty associated with exchanging one foreign currency for another.  From the perspective of the exporter's credit department dealing with an invoice denominated in the buyers national currency, the seller's credit manager must not only concern themselves with credit risk and sovereign risk, the seller must also be concerned about the ability to convertability of that foreign currency.  As a rule, the more difficult it is to convert one currency into another, the less the exporter will receive when the foreign currency has been exchanged for the currency in use in the seller's country. The simplest way for a U.S. based seller to avoid foreign exchange risk is to quote foreign customers in U.S. dollars and require payment in U.S. dollars. This way, all the risks associated with fluctuations in foreign-exchange rates are borne by the buyer.

In my opinion, it is important to develop written foreign currency policies and procedures.  These policies and procedures should be written with the company goals related to foreign exchange management in mind.  This document should specify the type(s) of hedging the company will engage in, and indicate the authority levels required to hedge specific amounts of FX risk, or to decide that hedging is not required.

Edited by Michael C. Dennis.  Mr. Dennis is a consultant.  He can be reached by email at mcdennis13@yahoo.com with questions, comments or business inquiries.