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Managing Foreign Exchange Rate Risks
In export sales transactions, buyers and sellers rarely use the same currency, and the relative value of their respective currencies is volatile meaning that it constantly changes. One of the decisions faced by U.S. exporters will be whether or not to require payment from foreign buyers in in U.S. dollars or in another currency such as the Euro or the Yen.
Depending on if the sale is denominated in the buyer's nation's currency or the seller's nation's currency or a third 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 for this reason that most U.S. based exporters prefer that sales to foreign customers be invoiced in U.S. dollars and paid for in U.S. dollars. [Of course, this is the same reason that sellers prefer to be invoiced in their national currency rather than in U.S. dollars].
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.
There are several methods used to limit foreign exchange risk. One involves simply adding a margin buffer to any invoice quoted in a foreign currency. Another method involves a contractual arrangement with the buyer involving what commonly called a currency window. A currency window is a mechanism by which the buyer and seller in a sense share the risk of significant fluctuations in foreign exchange rates between the time the invoice is generated and the date on which the payment is made. A third technique is to hedge against foreign exchange rate changes. A hedge is any financial tool used to transfer part or all of the FX related risk away from the seller.
Note: 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. However, it is possible to be paid in a foreign currency and offset the foreign exchange risks by purchasing contracts through banks or other financial institutions that allow the seller to "hedge" against foreign exchange fluctuations.
Companies interested in hedging should know that it is complex, requires a degree of expertise, requires sound advice from an expert [possibly someone working for the exporter's bank] and that the seller will incur certain costs to hedge against significant swings in the relative values of two currencies.
© 2010 by Michael C. Dennis. All Rights Reserved. Excerpted from "Credit and Collection Handbook" by Michael C. Dennis