FX = A two letter migraine
Why do people get so freaked out by foreign currency rates and transactions? Many American companies that sell internationally simply refuse to transact business in any currency other than U.S. Dollars (USD.)
There are legitimate reasons for taking that position - but complexity and risk aren't among them.
Let's take a quick look at what's involved. (Here's a hint...it's not worth a headache. In fact, it's pretty easy.)
Obiligatory disclaimer - this isn't financial, legal or accounting advice for you to act upon directly. This is information to help you have the right discussions with bankers & accountants.
You manage spot & hedge transactions every day
Did you ever sign a lease that locked in the price today which you would pay 4 years from now?
Or entered into a bulk purchasing agreement today, for more than you need immediately, in exchange for a lower price on everything your're buying?
You almost certainly have.
How about buying concert tickets the day they went on sale because you knew they'd cost more later if you had to buy them from an agent - or maybe waited to buy sports tickets because you thought the team might not do so well and you might buy them cheaper in the future from a scalper?
How about waiting to buy something until Black Friday or after Christmas sales?
And have you ever used a specific account or credit card knowing that based on the statement closing date you'd have additional time until you actually had to pay for your transaction?
Those are all forms of forward and spot transactions which are very similar to the simple process you company can use to manage foreign currency transactions.
Fix a price
When you sign a lease, or enter into a long-term/bulk purchasing agreement you are protecting yourself against future price increases and locking in a cost so that you know what your fixed or variable costs will be. Of course you run a risk - if real estate or commodity prices fall in the meantime you may end up paying a higher price than you would if you negotiated annually or with each transaction.
Generally, though, that's a minor risk, and the security of having a fixed cost is advantageous for forecasting and budgeting.
You can easily do precisely the same thing with foreign currency. Let's do a quick example:
Let's say you're selling something to a Canadian customer.
- They will order today with a down payment, it will ship to them in 30 days, and payment for the balance will be due in 30 more days (60 days from now.)
- In order to maintain your 30% margin you need to receive USD$100 - $20 today with the order and $80 in 60 days
- The value of the Canadian Dollar (CAD) today is USD .80 - in other words it costs only 80 US cents to buy one Canadian dollar. (But you remember that three years ago it might have cost you $1.20 US to buy a single CAD!) So you know the value can change, and you can't afford to lose any of your margin.
- So first you set the price with the customer - they will pay you CAD $125 (so based on today's price you know that you receive the USD $100 you must have)
- Then you call your bank and tell them that:
- in a couple days you'll be calling to "sell them" roughly CAD $25 ($20 USD down payment at $.80) - and you want them to pay you in US Dollars
- in a couple months you'll be calling to sell them another CAD $100 ($80 USD balance)
- you want to lock in today's rate for both
- It's really that simple - just like your lease, you know today that the CAD $100 you'll receive in 60 days will turn into USD $80 in your account.
Or Wager on the market
Now, remember how you decided to wait to buy those Yankees tickets on the 3rd base line because by September they'll be completely out of playoff contention? And you figure you'll pick up a couple great seats from a scalper for much less than they cost you today.
Or maybe the way you're waiting to buy something until the after Christmas sales?
So let's say you very strongly believe that the value of the Canadian dollar will rise over the next 60 days. If you're right, the CAD $100 you receive then may be worth even more USD. For instance, if it strengthened to .85, those CAD would now net you USD $85 ($5 / 6.25% more than if you bought them today.) That would boost your margin on the transaction from 30% to just over 33%.
Of course....you could be wrong. And in that case your margin would be compressed.
This can be risky.
You business is bending and welding steel - you're not a hedge fund. So in most cases you'll be better simply locking in your profits at the time of the transaction.
It's not Enron or rogue traders
Part of the hangup is that hedging, options, forwards, spot and similar industry terms carry a lot of baggage. And it's true that if you're trading billions of dollars and make silly mistakes you can be quickly wiped out.
That's not the game you'll play. So here's a quick glossary of terms:
- Spot - buying it now at the prevailing price
- Forward - make an agreement today, at a known price, to do a transaction in the future (you can set a specific date, or establish a range of dates)
No Wharton finance degree required!
What a bank will require
The bank's risk is that you'll enter into a transaction and not pay. They won't be stuck holding the foreign currency since they can turn around and sell it. However, their risk is that when they sell it it may be worth less than when they bought it on your instructions. So generally they'll ask for a small deposit on forwards (maybe a few percent - often can be held against a rotating credit line you have with them) to cover the risk they face if you default.
And there's some cost for the transaction - maybe .5%. Consider adding that into your pricing before hand.
But here's what is potentially the biggest hurdle in the whole process. Your current commercial bank is likely ill suited to support this requirement - even if your loan officer glibly assures you "Oh, sure, we have someone that handles that." You'll want a bank (in my experience easier than a broker) where you can form a relationship with one or two people on the trading desk.
I've found small banks with an established FX departments will have the patience and expertise to help you manage transactions - even support you by phone and answer questions instead of forcing you to use an online trading platform that can feel intimidating.
They'll have account agreements and trade agreements that you'll have to sign (just as if you set up a new private bank or brokerage account.)
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Why your customers will love you
If I'm going to grab a beer or a sandwich, more and more I go to the place that takes credit cards. I just don't carry cash very often.
It's not an exact analog, but it's a matter of comfort and convenience for the customers. AND, since you're going to take the currency risk (but hedge it so you don't have any exposure) you'll give them the comfort of a fixed price. They know what they're going to pay in the currency they work in.
You're a better vendor - easier to do business with and more empathetic.
But what if they don't pay
Here's the other big concern. If you sell foreign buyers in their currency you have a choice to require payment in advance (you can still lock in a price as noted above - for instance at 30 days/time of shipment) or carry a balance on account terms.
EVERYBODY worries about how to collect aging receivables internationally. And the truth is that it's tough (although everyone seems to think that collecting domestically is easy.....)
But there's a solution. Receivables insurance can be purchased relatively inexpensively (both premium and deductible.) Some products only cover foreign receivables (e.g. Ex-Im Bank) while others cover foreign and domestic. Underwriting requirements vary but there are some benefits to the couple points that you may pay in premium. These include:
- Investigative resources - there aren't many good ways to research the credit worthiness of foreign buyers. In most cases you can't just "pull a D&B." When you buy insurance you essentially hand that responsibility off to a group that's got resources to do that due diligence. If they come back and say they won't cover a particular buyer - you've gotten an answer you likely wouldn't have been able to track down yourself.
- Create bankable assets - in most cases banks will allow you to include a substantial portion of the insured foreign receivables in your asset base for borrowing calculations
Credit insurance resources include:
Products and terms/conditions vary with each. Reporting requirements, premiums, deductibles, acceptable reason for non-payment, term of delinquency to qualify and other details are important to understand.
Longer term considerations
There is a risk that you can't hedge directly - that's the long-term fluctuation of relative currency valuations.
If you took advantage of the secular weakness of the USD from 2004-2010 to build large export sales (since a weak dollar made your products cheaper for most foreign buyers) then as the USD regained strength in 2014-2015 you would may have seen some of those sales decrease.
There's really no easy way around that. However there are a couple factors to consider.
First, if you're diversified, you probably find that not all markets/currencies move to the same degree.
Second, as the dollar strengthens you're going to see more competition domestically too (imports become more affordable.) The point is that currency fluctuations affect your business - even if you're not selling internationally!
Want to learn more about managing FX for your industrial manufacturing SMB? Download this free guide that covers the basics.