Description
Foreign exchange (FX) is a risk factor that is often overlooked by small and medium-sized enterprises (SMEs) that wish to enter, grow, and succeed in the global marketplace.
25
TRADE FINANCE GUIDE
Chapter 12
Foreign Exchange Risk
Management
F
oreign exchange (FX) is a risk factor that is often overlooked by small and medium-
sized enterprises (SMEs) that wish to enter, grow, and succeed in the global market-
place. Although most U.S. SME exporters prefer to sell in U.S. dollars, creditworthy
foreign buyers today are increasingly demanding to pay in their local currencies. From the
viewpoint of a U.S. exporter who chooses to sell in foreign
currencies, FX risk is the exposure to potential financial
losses due to devaluation of the foreign currency against
the U.S. dollar. Obviously, this exposure can be avoided
by insisting on selling only in U.S. dollars. However, such
an approach may result in losing export opportunities to
competitors who are willing to accommodate their foreign
buyers by selling in their local currencies. This approach
could also result in the non-payment by a foreign buyer
who may find it impossible to meet U.S. dollar-denomi-
nated payment obligations due to the devaluation of the
local currency against the U.S. dollar. While coverage for
non-payment could be covered by export credit insurance,
such “what-if” protection is meaningless if export oppor-
tunities are lost in the first place because of the “payment
in U.S. dollars only” policy. Selling in foreign currencies, if
FX risk is successfully managed or hedged, can be a viable
option for U.S. exporters who wish to enter and remain
competitive in the global marketplace.
Key Points
• Most foreign buyers generally prefer to trade in their
local currencies to avoid FX risk exposure.
• U.S. SME exporters who choose to trade in foreign
currencies can minimize FX exposure by using one
of the widely-used FX risk management techniques
available in the United States.
• The volatile nature of the FX market poses a great risk
of sudden and drastic FX rate movements, which may
cause significantly damaging financial losses from
otherwise profitable export sales.
• The primary objective of FX risk management is to minimize potential currency
losses, not to make a profit from FX rate movements, which are unpredictable and
frequent.
CHARACTERISTICS OF A
FOREIGN CURRENCY
DOMINATED EXPORT SALE
Applicability
Recommended for use (a) in competitive markets
and (b) when foreign buyers insist on trading in
their local currencies.
Risk
Exporter exposed to the risk of currency exchange
loss unless a proper FX risk management technique
is used.
Pros
• Enhances export sales terms to help exporters
remain competitive
• Reduces non-payment risk because of local
currency devaluation
Cons
• Cost of using some FX risk management
techniques
• Burden of FX risk management
-
FX Risk Management Options
A variety of options are available for reducing short-term FX exposure. The following sec-
tions list FX risk management techniques considered suitable for new-to-export U.S. SME
companies. The FX instruments mentioned below are available in all major currencies and
are offered by numerous commercial lenders. However, not all of these techniques may be
available in the buyer’s country or they may be too expensive to be useful.
Non-Hedging FX Risk Management Techniques
The exporter can avoid FX exposure by using the simplest non-hedging technique: price
the sale in a foreign currency. The exporter can then demand cash in advance, and the cur-
rent spot market rate will determine the U.S. dollar value of the foreign proceeds. A spot
transaction is when the exporter and the importer agree to pay using today’s exchange rate
and settle within two business days. Another non-hedging technique is to net out foreign
currency receipts with foreign currency expenditures. For example, the U.S. exporter who
exports in pesos to a buyer in Mexico may want to purchase supplies in pesos from a differ-
ent Mexican trading partner. If the company’s export and import transactions with Mexico
are comparable in value, pesos are rarely converted into dollars, and FX risk is minimized.
The risk is further reduced if those peso-denominated export and import transactions are
conducted on a regular basis.
FX Forward Hedges
The most direct method of hedging FX risk is a forward contract, which enables the
exporter to sell a set amount of foreign currency at a pre-agreed exchange rate with a
delivery date from three days to one year into the future. For example, suppose U.S. goods
are sold to a Japanese company for 125 million yen on 30-day terms and that the forward
rate for “30-day yen” is 125 yen to the dollar. The U.S. exporter can eliminate FX exposure
by contracting to deliver 125 million yen to his bank in 30 days in exchange for payment
of $1 million dollars. Such a forward contract will ensure that the U.S. exporter can con-
vert the 125 million yen into $1 million, regardless of what may happen to the dollar-yen
exchange rate over the next 30 days. However, if the Japanese buyer fails to pay on time,
the U.S. exporter will be obligated to deliver 125 million yen in 30 days. Accordingly, when
using forward contracts to hedge FX risk, U.S. exporters are advised to pick forward deliv-
ery dates conservatively. If the foreign currency is collected sooner, the exporter can hold
on to it until the delivery date or can “swap” the old FX contract for a new one with a new
delivery date at a minimal cost. Note that there are no fees or charges for forward contracts
since the lender hopes to make a “spread” by buying at one price and selling to someone
else at a higher price.
FX Options Hedges
If there is serious doubt about whether a foreign currency sale will actually be completed
and collected by any particular date, an FX option may be worth considering. Under an
FX option, the exporter or the option holder acquires the right, but not the obligation, to
deliver an agreed amount of foreign currency to the lender in exchange for dollars at a
specified rate on or before the expiration date of the option. As opposed to a forward con-
tract, an FX option has an explicit fee, which is similar to a premium paid for an insurance
policy. If the value of the foreign currency goes down, the exporter is protected from loss.
On the other hand, if the value of the foreign currency goes up significantly, the exporter
can sell the option back to the lender or simply let it expire by selling the foreign currency
on the spot market for more dollars than originally expected, but the fee would be forfeited.
While FX options hedges provide a high degree of flexibility, they can be significantly more
costly than FX forward hedges.
U. S. Department of Commerce
International Trade Administration
26
doc_150657371.pdf
Foreign exchange (FX) is a risk factor that is often overlooked by small and medium-sized enterprises (SMEs) that wish to enter, grow, and succeed in the global marketplace.
25
TRADE FINANCE GUIDE
Chapter 12
Foreign Exchange Risk
Management
F
oreign exchange (FX) is a risk factor that is often overlooked by small and medium-
sized enterprises (SMEs) that wish to enter, grow, and succeed in the global market-
place. Although most U.S. SME exporters prefer to sell in U.S. dollars, creditworthy
foreign buyers today are increasingly demanding to pay in their local currencies. From the
viewpoint of a U.S. exporter who chooses to sell in foreign
currencies, FX risk is the exposure to potential financial
losses due to devaluation of the foreign currency against
the U.S. dollar. Obviously, this exposure can be avoided
by insisting on selling only in U.S. dollars. However, such
an approach may result in losing export opportunities to
competitors who are willing to accommodate their foreign
buyers by selling in their local currencies. This approach
could also result in the non-payment by a foreign buyer
who may find it impossible to meet U.S. dollar-denomi-
nated payment obligations due to the devaluation of the
local currency against the U.S. dollar. While coverage for
non-payment could be covered by export credit insurance,
such “what-if” protection is meaningless if export oppor-
tunities are lost in the first place because of the “payment
in U.S. dollars only” policy. Selling in foreign currencies, if
FX risk is successfully managed or hedged, can be a viable
option for U.S. exporters who wish to enter and remain
competitive in the global marketplace.
Key Points
• Most foreign buyers generally prefer to trade in their
local currencies to avoid FX risk exposure.
• U.S. SME exporters who choose to trade in foreign
currencies can minimize FX exposure by using one
of the widely-used FX risk management techniques
available in the United States.
• The volatile nature of the FX market poses a great risk
of sudden and drastic FX rate movements, which may
cause significantly damaging financial losses from
otherwise profitable export sales.
• The primary objective of FX risk management is to minimize potential currency
losses, not to make a profit from FX rate movements, which are unpredictable and
frequent.
CHARACTERISTICS OF A
FOREIGN CURRENCY
DOMINATED EXPORT SALE
Applicability
Recommended for use (a) in competitive markets
and (b) when foreign buyers insist on trading in
their local currencies.
Risk
Exporter exposed to the risk of currency exchange
loss unless a proper FX risk management technique
is used.
Pros
• Enhances export sales terms to help exporters
remain competitive
• Reduces non-payment risk because of local
currency devaluation
Cons
• Cost of using some FX risk management
techniques
• Burden of FX risk management
-
FX Risk Management Options
A variety of options are available for reducing short-term FX exposure. The following sec-
tions list FX risk management techniques considered suitable for new-to-export U.S. SME
companies. The FX instruments mentioned below are available in all major currencies and
are offered by numerous commercial lenders. However, not all of these techniques may be
available in the buyer’s country or they may be too expensive to be useful.
Non-Hedging FX Risk Management Techniques
The exporter can avoid FX exposure by using the simplest non-hedging technique: price
the sale in a foreign currency. The exporter can then demand cash in advance, and the cur-
rent spot market rate will determine the U.S. dollar value of the foreign proceeds. A spot
transaction is when the exporter and the importer agree to pay using today’s exchange rate
and settle within two business days. Another non-hedging technique is to net out foreign
currency receipts with foreign currency expenditures. For example, the U.S. exporter who
exports in pesos to a buyer in Mexico may want to purchase supplies in pesos from a differ-
ent Mexican trading partner. If the company’s export and import transactions with Mexico
are comparable in value, pesos are rarely converted into dollars, and FX risk is minimized.
The risk is further reduced if those peso-denominated export and import transactions are
conducted on a regular basis.
FX Forward Hedges
The most direct method of hedging FX risk is a forward contract, which enables the
exporter to sell a set amount of foreign currency at a pre-agreed exchange rate with a
delivery date from three days to one year into the future. For example, suppose U.S. goods
are sold to a Japanese company for 125 million yen on 30-day terms and that the forward
rate for “30-day yen” is 125 yen to the dollar. The U.S. exporter can eliminate FX exposure
by contracting to deliver 125 million yen to his bank in 30 days in exchange for payment
of $1 million dollars. Such a forward contract will ensure that the U.S. exporter can con-
vert the 125 million yen into $1 million, regardless of what may happen to the dollar-yen
exchange rate over the next 30 days. However, if the Japanese buyer fails to pay on time,
the U.S. exporter will be obligated to deliver 125 million yen in 30 days. Accordingly, when
using forward contracts to hedge FX risk, U.S. exporters are advised to pick forward deliv-
ery dates conservatively. If the foreign currency is collected sooner, the exporter can hold
on to it until the delivery date or can “swap” the old FX contract for a new one with a new
delivery date at a minimal cost. Note that there are no fees or charges for forward contracts
since the lender hopes to make a “spread” by buying at one price and selling to someone
else at a higher price.
FX Options Hedges
If there is serious doubt about whether a foreign currency sale will actually be completed
and collected by any particular date, an FX option may be worth considering. Under an
FX option, the exporter or the option holder acquires the right, but not the obligation, to
deliver an agreed amount of foreign currency to the lender in exchange for dollars at a
specified rate on or before the expiration date of the option. As opposed to a forward con-
tract, an FX option has an explicit fee, which is similar to a premium paid for an insurance
policy. If the value of the foreign currency goes down, the exporter is protected from loss.
On the other hand, if the value of the foreign currency goes up significantly, the exporter
can sell the option back to the lender or simply let it expire by selling the foreign currency
on the spot market for more dollars than originally expected, but the fee would be forfeited.
While FX options hedges provide a high degree of flexibility, they can be significantly more
costly than FX forward hedges.
U. S. Department of Commerce
International Trade Administration
26
doc_150657371.pdf