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Spring 1997 - Volume 2, No. 4

Currency Exchange Risk Management:
Setting up a strategy to hedge on foreign exchange markets

by Guy J. Engon

Doing business abroad has never been an easy feat. You have to be able to conclude the transaction. Then you have to make sure you get paid, which as many exporters can attest, is not a given. As if this was not complicated enough, exporters now run the risk of losing revenue due to fluctuations on the foreign exchange market when the transaction is conducted in a foreign currency. Slight fluctuations in the value of a currency relative to the dollar can translate into losses of thousands of dollars or more, according to the size of the transaction. Last February for instance, one dollar was worth 1.6406 DMark. On May 6, it was exchanged for 1.7325 DMark. An American exporter selling products in Germany for an amount of 100,000 DM would receive $57720 instead of $60953 had he received the payment 4 months ago. The loss would amount to a little more than three thousand dollars.

Evidently, the fluctuation would have resulted in a gain had the dollar fallen relative to the foreign currency. But even that means you have to keep an eye on the foreign exchange market.

If the transaction partner is located in a country with a currency that is difficult to track, the problem can become even more acute.

The foreign exchange markets now being more unstable than they used to be, companies that deal with international markets will have to design strategies to manage foreign exchange risk and hedge against the fluctuations. How do you do that? First of all, it's all a matter of which party will bear the risk, and that will depend on the different bargaining positions. Of course, the best solution for the US exporter is to get paid in US dollars, but most foreign clients will probably be reluctant to comply. Moreover, the transaction currency increasingly becomes a crucial element of the offering package. Insisting on a US dollar payment can therefore make you lose customers. Another solution is to do nothing, which amounts to speculation, with all the risks involved.

Besides those two options, companies can now use a broad range of financial arrangements to reduce or eliminate their exposure, and the choice between those instruments will depend on the nature of the exposure and how the company manages risk. The most widely used financial arrangements are the forward market and the options. The forward market allows the exporter to exchange two currencies on a future date at an agreed rate, therefore enabling it to cover itself, were any fluctuation to occur. In an option contract, the exporter agrees to buy foreign exchange on any date between a set period of time, at a rate set conjointly with the bank. Companies generally use options when they need to cover their exposure over a very long period ranging from 6 months to one year.

Numerous (and more complicated) instruments exist, but before deciding among all of them, you will have to determine whether you handle the risk management yourself or have somebody do it for you. Larger companies tend to have their own risk management strategy, with people dedicated to that single task, mainly because of the size of the contracts they have to deal with. However, inexperienced exporters or those who have to deal with a currency or a market they are not familiar with, will be well advised to use banks or export management companies. Most larger banks have international risk management groups that conduct research on a country by-country-basis and can provide exporters with the expertise and resources that tracking foreign exchange fluctuations usually requires. The bank fee is evidently an additional cost, but it's usually money well spent.

However, in choosing a bank, exporters should look at much more than the fees it charges. Ask questions. Make sure the bank is ready to meet your particular needs (not all are) and will provide you with the proper support when needed. Export management companies also provide such services and can be as effective as the banks. On the whole, the technique exporters use and how they use it will depend on the particular transaction they have to deal with and their corporate policy. And it is important not to lose sight of those financial instruments: to hedge, not to speculate. It may be a conservative approach, but it will save you a whole lot of trouble and money in the long run.

Guy J. Engon is an international trade intern at the Tennessee Export Office. A native from Cameroon and an international business major, he comes from the Business Administration School of Normandy, in France. He has worked in the international operations of several midsize French companies, dealing with the European and African markets.

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