In January 2003, the CFO of a Michigan-based auto parts manufacturer reviewed his capital budget with his firm's Budget Committee. One conspicuous line item identified the cost of retooling the company's parts plant in Asia.

But from February 2002 to September 2003, the value of the U.S. dollar decreased by 17 percent, according the Federal Reserve's Nominal Major Currencies Dollar Index. As a result, the actual cost to retool the Asian parts facility was millions of dollars more than anticipated. This oversimplified scenario illustrates the need for exporters, importers or companies with overseas subsidiaries to factor foreign exchange risk into their budgets.

The Impact of Currency Volatility

Although exchange rates usually move gradually over time, they have been known to fluctuate with extreme volatility. This not only can reduce corporate profits, but can put companies out of business and economies into recession.

For example, on December 20, 1994, an attempted currency adjustment by the Mexican government accelerated out of control. Within two days pressures mounted; currency reserves used to prop up the peso quickly dwindled. As a result, the peso was allowed to float freely. Shortly thereafter, it nose-dived. Like falling dominoes, the ensuing panic spread to Brazil and Argentina, whose currencies also dropped precipitously.

The impact of the 1997 Asian financial crisis was felt worldwide. With front page news of plunging currencies — beginning with the Thai baht and quickly affecting the Malaysian ringgit, the Indonesian rupiah, and the Korean won — the tremendous damage caused by currency fluctuations became evident. Not only did the domino effect put pressure on traditionally strong currencies, but it also resulted in economic recession in several countries.

When budgeting for expenses and revenues from overseas transactions, clearly CFOs must manage and account for minimal, as well as potentially severe, currency fluctuations

Minimize Foreign Exchange Exposure

A purchase contract that is signed on January 1 with a foreign currency payment due on February 1 represents 30 days of foreign exchange exposure. Consequently, a U.S. exporter who sells goods to Germany (priced in euros) runs the risk of collecting euros in 30 days at a depreciated rate when they are converted into dollars.

Should this occur, the exporter will receive lower than expected revenue — which must be accounted for in the budget. On the other hand, a U.S. importer who buys French wine (also priced in euros) will benefit if the euro rises compared to the dollar, making the same case of burgundy less expensive.

Due to fluctuating exchange rates, CFOs should seek to stabilize cash flows and reduce uncertainty in their financial forecasts. In doing so, they must consider the three most important factors that impact currency exchange: foreign exchange exposure, the expected and actual rate of exchange, and the date the exchange actually occurs. In doing so, a variety of interest rate hedges may be used.

Employ Foreign Exchange Contracts

Contracts are one way to hedge against foreign exchange risk and bring certainty into the budget process. Spot contracts deal with the exchange of currency that deal with a contract term of two business days. (This two-day period applies to all currency with the exception of the Canadian dollar.)

For the purposes of establishing an annual budget, a forward contract may be an ideal tool. This locks in the future foreign currency purchase price at the time of agreement. To determine the rate of exchange, two items must be factored in: the current spot rate and the forward rate adjustment, which involves the interest rates of the currencies in question and the time frame between contract date and settlement date.

Overall, currency volatility requires CFOs to account for all risks when deciding which projects to finance and how to fund them. If they use the Net Present Value (NPV) method of evaluating budgets for a foreign project, the parent company could hedge against currency risk, especially if the NPV of the project is greater then the NPV to the company.

Foreign exchange risk can be shown on the projected balance sheet when the firm discounts foreign currency cash flow at the foreign discount rate, and converts it at the current spot rate. Or, the foreign exchange risk can be converted at a future spot rate and discount domestic cash flows at the domestic discount rate. Often, either a higher discount rate can be applied for what is conceived to be a riskier investment or project — or expectations of cash flows from the project can be reduced.

Borrowing in the Global Market?

Borrowing for a project in foreign currency can provide a sound solution, and the cost of borrowing from the global capital market is generally less than the cost of borrowing domestically.

However, host-government regulations or demands may drive up the discount rate used in capital budgeting. Nevertheless, the discount rate should be appropriate for the risk of the cash flow.

Consider Hedging

In addition to adjusting capital budgeting, there are many ways to hedge against exposure to foreign exchange risk. These include:

  1. Buying forward
  2. Using currency swaps
  3. Leading and lagging payables and receivables
  4. Manipulating transfer prices
  5. Using local debt financing
  6. Accelerating dividend payments

Control Risk by Recognizing and Controlling Exposure

In today's dynamic global economy where currency values constantly fluctuate, it is necessary to monitor your exposure and risk-control activities measures. And when deciding which hedges to employ, a reasonable idea of future exchange rate movements is helpful.

But perhaps most importantly, your company should consider monitoring exposure to make adjustments to the annual budget as needed.

This article appeared in Crain's Detroit Business, September 2003. (CO)

John Manzella
About The Author John Manzella [Full Bio]
John Manzella, founder of the, is a world-recognized speaker, author and an international columnist on global business, trade policy, labor, and economic trends. His latest book is Global America: Understanding Global and Economic Trends and How To Ensure Competitiveness.

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