How To Reduce Currency Risks While Making Your Exports More Attractive

The United States has less than 5 percent of the world’s population. Yet the World Bank says the country accounts for 20 percent of global GDP output. For years our large market satisfied the goals of American manufacturers. But that has changed. And when considering CIA data that indicates our growth rates are lower than 150 other countries, it becomes obvious that U.S. companies need to seek faster growing markets abroad.

A portion of the world’s population is inaccessible for a variety of reasons: poor local distribution channels, infrastructure challenges, and in rare cases, sanctions, etc. But, even when one considers the lure of potentially new markets, falling manufacturing costs, and the metaphorical dissolution of borders, exporting is more practical and more profitable than ever. It is not without risk, though.

Next Stop, Parity

First and foremost, there are plenty of currency risks. In the past six months, the U.S. dollar has unquestionably been the belle of the ball in global currency markets. The only other significant currency of note that has even come close to matching its performance has been the Swiss Franc — thanks entirely to a Barry Bonds sized dose of performance-enhancing intervention. With political turmoil in Europe and relatively strong economic performance in the U.S., one can expect this trend to continue.

Against the euro, there seems to be nothing preventing the dollar from racing back below parity, a level not seen since shortly after we weathered the Y2K scare. In fact, by the time you finish reading this article, we might already be through the psychologically significant level. This would be on top of the near 22 percent gains realized since July.

The single currency isn’t alone. Similar gains have been booked against many of the dollar’s rivals as evidenced by the near 18 percent rise in the U.S. Dollar Index, according to Investing.com. The Index represents the value of the U.S. dollar versus a trade weighted basket of currencies. As you would expect, similar gains have been booked by the heavier weighted currencies in that index. According to Oanda.com, the Buck has risen by 17 percent against the CAD, 16 percent against the JPY, 13 percent against the GBP, and was flat versus the CNY. You can’t win them all.

The move has importers and those holding “short” (i.e. need to buy the currency) euro, et. al. positions rejoicing. It has been a virtual one way street since July, much to their delight.

The End is Not Near

Exporters, however, and those with an implied “long” position (i.e. need to sell the currency) are not doing as much celebrating. Their wares have, in the past two quarters, received an implied price hike of 15 to 20 percent overseas. For fear of making the product less attractive to local competition overseas, this often comes out of the manufacturer’s or exporter’s bottom line. This trend seems set to continue.

All is not lost, though. There are tools available even to the smallest companies conducting international business. These tools offer protection from foreign currency exposure; be it payables or receivables. Forward contracts are the most common tool, but futures contracts, and options contracts also serve to hedge those exposures, cap downside risk, and, barring some catastrophic event, assure the buyer a set amount of proceeds upon maturity.

Forwards and futures are very similar and relatively easy to understand. The former can be customized with respect to amounts and delivery dates. The latter comes with predefined terms.

Options tend to be more complex. Though they generally allow for more flexibility and occasionally some upside participation, one really should make an effort to understand all of the inputs and potential outcomes given the inevitable changes to those inputs. (Just a hint: the old poker adage of “Look around the table. If you can’t see the sucker, you’re it” rings especially true here. Know what you are getting into.)

Just So We’re All Clear

The most important part of a proper hedging strategy is defining exactly what you need to hedge. A U.S. company selling domestically knows how much it can expect for its wares. For a U.S. company selling internationally, things aren’t as clear. Invoicing in dollars seems to make sense operationally, but keep in mind, it might cost your customer on the other end much more.

In the following example, for the $100,000 to be paid in installments by a customer in Europe, note that the customer ends up paying €7 thousand more than they would have in the presence of a hedge.

Invoicing in local currency alleviates the administrative burden from the customer and makes importing more attractive, but it doesn’t solve the problem. The unhedged euro position is worth $12 thousand less in the absence of a hedge at the time of settlement. (Both examples assume a deal date of June 1, with 20 percent due July 15, 30 percent due October 15, and the 50 percent balance due January 15.)

You Win Some, You Win Some More

Another often overlooked advantage of some of these tools is that they tend to keep your cash flow free. Though not immune to deposits, premiums, or margin, which typically only amount to a fraction of the notional value of the hedge, you only need to pay for them when they mature, or in the case of options, if they are executed.

Regardless of which side of the market you are on and regardless of the direction of the underlying exchange rate, having an appropriate hedge in place is key. All well and good to avoid downside risk, but what of missing out on the upside? If you have owned a home in the past 8 to 10 years, you know that no rally lasts forever.

There will be periods of sharp dollar declines, too. You can take that to the bank. Much less certain — and infinitely more important is the timing of these declines.

From the exporter perspective, it would be difficult to see these potential “gains” slipping away because you had hedged your revenues ahead of time. To this, I would say serendipity is not a sustainable business model. Yes, you might be missing out on what you perceive to be “gains,” but, unless you are a currency trader at a bank or hedge fund, your “gains” should be made on running your business, growing sales, and realizing efficiencies in your operations — things within your control.

Executive board rooms cheer efficiencies in their own operations. Not stumbling into revenues because certain factors well beyond their control conspire to work in their favor once or twice. They celebrate and reward proper risk management strategies. Hedging is perhaps the most important risk management strategy that an importer or exporter can deploy.

About The Author Peter Clifford

Peter Clifford is the Co-Founder of TRSRY, LLC., an early stage financial technology company specializing in foreign currency hedging and payment services for corporations.