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Currency Risk Management - Critical to Global Market Success

This post highlights the risks associated with trading in global markets, the need for a strategy to mitigate currency exposure & how to gain success.

As increasingly more businesses are jumping into overseas markets, it’s crucial for business owners to understand the need for a strategy to mitigate currency exposure and the risks associated with buying and selling overseas. “Most people want to trade at the best rate in the market,” says Ken Hogan, Head of Foreign Exchange for Cadence Bank, “but the ultimate goal should be removing volatility in the market from your business transactions.” 
 
Hogan suggests the initial step to establishing a currency risk management strategy depends on whether your company is buying or selling—because they pose different challenges. Although this might sound obvious, the first question a company selling U.S. goods in a foreign country should ask is, “Can the currency in the country I’m doing business with be repatriated into the U.S.,” he said. In other words, some currency is not tradable outside the country’s borders due to central bank restrictions—posing difficulties for U.S. companies exporting goods. 
 
“You can’t assume that every foreign currency can be freely traded for U.S. dollars,” says Hogan. “I’ve seen this first hand. Several years ago we advised a client exporting goods to Malaysia to put the brakes on a $25 million contract that was payable in Ringgits. They didn’t know Malaysian Ringgits were a restricted currency at that time and they would not have been able to move the money out of Malaysia. This was a small firm, so this transaction could have put them out of business.” 
 
However, firms must also be wary of doing business exclusively in U.S. Dollars. In fact, this could be the riskiest way to conduct global trade as it leaves them fully exposed to  exchange rate volatility. 

 

The implications are significant for both importers and exporters. For importers, assume you are purchasing equipment from Germany and your vendor agrees to be paid in U.S. Dollars instead of Euros. If the dollar depreciates against the Euro during the invoicing period, your payment to the German vendor will translate into fewer Euros—resulting in a loss for the vendor. 

 

To compensate for a possible depreciation of the dollar, it’s common practice for foreign vendors to add a “cushion” to your U.S. Dollar invoice to protect themselves against a weakening dollar. Depending on the length of the invoice and the currencies involved, cushions of five to 10 percent of the total cost of the invoice are not uncommon. 

If the dollar were to strengthen, you not only would have overpaid for the machinery because you could have made the purchase in Euros at a lower cost, but you also would have paid an additional amount due to the hidden cushion added to your invoice. 

A Dual-Currency Invoicing strategy is an effective way to manage FX risk. This allows companies to see the cost of goods in both the local currency and U.S. Dollars, thereby enabling them to make payment in the currency with the lowest cost. 

Hogan adds, “Dual-Currency Invoicing is a great strategy for managing currency risk because you either win or don’t lose.” Contacting a Cadence Bank FX expert is a quick and easy way to determine which currency pays the vendor exactly what they have requested while allowing the company to receive the optimal price. 

Exporters doing business exclusively in U.S. Dollars run the risk of losing business to competitors who offer the flexibility of pricing in local currencies. Instead of forcing your international customer to manage the exchange rate risk, companies could increase their sales if they quoted in the functional currency of their clients.  

Also, by offering prices in the local currency, you reduce settlement risk because your clients may either not have access to U.S. Dollars or may be unable to purchase them due to a weakened currency. In fact, Hogan recalls a time when he met with a firm who was selling goods to South Korea.

 

Rather than invoicing in Korean Won, the firm priced their Korean client in U.S. Dollars. During the invoicing period, the Korean Won had weakened so drastically that their client had to liquidate some commercial real estate in Seoul just to cover the difference. Hogan notes, “If the firm would have just offered pricing in Korean Won and entered into a basic hedge, their client could have kept their property!” 

The nuances of dealing with overseas markets and the associated currency is often something many first-time exporters and importers know little about. “It’s tempting for many business owners to think they can ‘play the market’ and wait for the rate they want,” added Hogan. “Unfortunately, that’s not hedging the market to remove volatility—it’s speculating. Which are two very different strategies.” 

Instead, Hogan advises establishing a budgeted exchange rate for all foreign currency transactions. In doing so, you have a benchmark foreign exchange rate by which to hedge your international transactions. “Because rates fluctuate, locking in a budgeted exchange rate is essential because it removes volatility, locks in profit margins and fixes costs.” 

Currency risk management experts like Hogan and his team of FX specialists can be invaluable assets to firms conducting business overseas as they can help you navigate the ever-changing landscape of the global markets. Even basic hedging strategies can help a business significantly mitigate currency exposure and the risks associated with trading in global markets. 

And beyond protecting a company’s margins, there also are new reporting requirements for corporate hedgers due to Dodd-Frank  Title VII requirements, Hogan added. 

This article is provided as a free service to you and is for general informational purposes only. Cadence Bank makes no representations or warranties as to the accuracy, completeness or timeliness of the content in the article. The article is not intended to provide legal, accounting or tax advice and should not be relied upon for such purposes.

 

 

 



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