Thursday, March 17, 2011

Foreign Exchange

Key terms in discussion foreign exchange (FX)
  • Hedging: managing against changes in the currency by either having a natural hedge (paying for it out of money earned in the Supplier’s country currency, or purchasing currency at a forward rate to use to make payments
  • Spot Rate: Exchange rate for an immediate transaction exchanging currency.
  • Forward Rate: The lock-in rate today for a currency exchange to take place in the future. Forward rates are driven by interest rate differentials between two countries and are not a prediction of the future rate of the currency.
  • Direct Currencies. Also referred to as being quoted in "American terms" so the quoted is U.S. dollars per 1 unit of the foreign currency.
  • Indirect Currencies. Quoted as amount of foreign currency per $1. In currency exchange rates posted most quotes will included both direct and indirect currencies.
  • Pricing currency: This is the currency in which prices are set which can be Buyer’s country currency, Seller’s country currency, or third country currency.
  • Payment currency is the Currency in which payment will be made. So while you could agree to the price in one currency you could also agree to make payment in a different currency based on the exchange rate. Actual payment needs to be made to the Supplier in the country where the sale is made.
  • Market based goods and services: Goods or Services where the market forces determine sales price and costs have little effect price.
  • Cost based goods and services: Goods or Services where Supplier's costs strongly affects price.
  • Pegged Currency Country. Currency is stable (or there is a fixed exchange rate) against an other currency. E,g, currencies that are tied at a fixed rate to the US Dollar.
  • Controlled Currency Country are those countries where the currency fluctuates within a band (i.e., +/- 5%) and is managed by their central bank
  • Floating Currency Country. These are countries where the exchange rate varies unpredictably against other currencies.

The Foreign Exchange Risk
If your are a US Company and the dollar weakens (or depreciates), the foreign currency will strengthen (or appreciates) against the dollar, so the dollar buys less foreign currency or foreign goods and services. If the price if the purchase is in the foreign currency a weakening dollar means the purchase will cost the same in the foreign currency but more in U.S. dollars. If the U.S. dollar strengthens (or appreciates), the foreign currency weakens (or depreciates) against the dollar,  so if the purchase price and payment currency were in the foreign currency, the dollar buys more foreign currency or foreign goods and services and the price of the purchase in a dollar equivalent will be less. Exchange risk is the risk of a change in the exchange rate affecting price paid or money received. The currency exchange risk is assumed by the party that doesn’t have their Country’s currency used. For example if you buy from Japan and you are based in the US but the price is in Yen, you have the risk if the exchange rate between the dollar and Yen changes. Exchange risks may also exist if a significant portion of their cost of their product or service is subject to exchange risks. For example, if you contracted to build a building in Singapore you would probably be paying the contractor in Singapore dollars so as between you and the Supplier you would have the currency risk. However if a majority of the materials and equipment needed came from Japan, the Supplier would also have exchange risks on those purchases.

The major risk from a procurement perspective is when exchange rates change they can either affect the Supplier’s cost to provide the product or service or affect the Buyer’s cost to buy the products. For immediate transactions the risk is minimal.

The greatest risk exists with firm commitments over extended periods where:
1.     The pricing is market based and highly volatile.
2.     The payment currency is in the Supplier’s or a third country Currency
3.     The selected country is based on Floating Country Currency so it is subject to major changes.

When negotiating contracts internationally you need to manage the impact of currency. Suppliers may be located in one country, buy materials from other countries, and then sell to customers in different countries. There are two major aspects of currency. The first occurs when the Supplier sells the product in the Buyer’s country and then must convert the currency into another currency so they can transfer out of the country. In countries that have tight currency controls this had driven companies to do unrelated activities simply to be able to repatriate their money. For example, at one time IBM established a trading company that would buy durable goods like shoes and shrimp in countries like Brazil to export them for sale in other countries where they could sell then and get a different currency as a means of getting their money out. This aspect of currency only applies in situations where there are tight currency controls. The other part of currency is currency exchange. Since the currency exchange rates between countries can vary on a daily basis based on the relative strength or weakening of the different currencies, this can impact the Supplier’s costs to purchase the materials, or the value of the proceeds from their sale of the product or service.

What Makes Exchange Rates Change?
 There are five main reasons why rates can change.
  1. Capital flows that are driven by Investors. If investors feel that one country's real returns will be greater than another and they decide to invest in that country, that country's currency will tend to strengthen and the country they pulled money out of will weaken..
  2. Fiscal and Monetary policies of the government and Central Bank such as spending and taxes. I was in Brazil on business where I experienced this first hand. A new government was elected and the government, in an attempt to reduce the hyperinflation that was occurring, proceeded to freeze everyone’s bank accounts. That dried up the money supply and caused the exchange rate to go from 80 cruzeros to the dollar to 28 cruzeros to the dollar overnight.
  3. Economic data.  Rates will vary based on the economic outlook. If an economy is improving, the news will tend to strengthen a currency.
  4. Balance of trade. If a country runs a balance of trade current deficit (it imports more goods than it exports), the theory is that the currency will tend to weaken over the long term.
  5. Currency reserves of the Central Bank A Central Bank can use its currency reserves to move its currency.  For example, the European Central Bank can sell U.S. dollars it holds and buy Euros to help strengthen the Euro.

Managing Foreign Exchange Risk

If the price is in Buyer’s currency (like U.S. Dollars) and the Buyer pays in their currency, all of the risk or benefits of currency exchange will be with the Supplier. If the Buyer’s currency appreciates in value versus the supplier’s currency, or the Supplier’s currency depreciates in value, the net result is the Buyer’s currency will buy more of the local currency and the Supplier will get the benefits of that because they will be paid in the Buyer’s currency (but their costs may be mainly in their currency).

If the Buyer’s currency depreciates in value versus the Supplier’s currency or the Supplier’s currency appreciates in value versus the Buyer’s currency, or the Buyer’ currency either depreciates versus the currencies of the countries where they have the majority of their cost of supply or those countries currencies appreciate in value versus the Buyer’s currency, the supplier will lose. This is because what they get paid will be worth less when converted into their local currency and it will buy less in their and other countries that a similarly impacted by the depreciation in the Buyer’s currency or appreciation of their currency.

For example: Buyer agrees to pay US$100 for a product purchased from a Japanese supplier. The Supplier may have agreed to that based on an expected exchange rate of 120 yen to a dollar. At 120¥ to a dollar it will yield them 12,000¥. If the exchange rate goes down to 100¥ per dollar it will yield them only 10,000¥ . If it goes up to 140¥ to the dollar, it will yield them 14,000¥.  In the first instance the loose because they will effectively receive 2,000¥ less than what they had received and since their costs are in yen, it will impact their profit. In the second instance they will receive 2,000¥ more than planned without their costs being impacted so it will increase their profit.

If you place 100% of the risk on currency exchange on the Supplier, the Supplier may be forced to carry a contingency in their price to cover the risk or the cost of currency management, especially in contracts where performance extends over a period of time. If they include the contingency, and the risk never occurs because either the exchange is stable or Buyer’s currency is appreciating, that contingency becomes pure profit for the Supplier.

If the Buyer wants to eliminate the contingency and Supplier’s currency risk from the relationship there are a number of alternatives they may use.
  • They could agree to pay in the Supplier’s currency, not their own. In that case buyer is assuming all the risk.
  • They could agree to pay in a third country currency that’s more stable in which buyer will also be assuming the risk between their currency and the other currency.
  • They can agree to establish the price based on what is called a “Band Width” basis where both parties share potentially in the risk. E.g. the Price is $20.00 US as long as the Yen is no less than 100 yen to a dollar or no more than 129 yen to a dollar. The challenge in any band width agreement is making sure that the establishment of the bands represents an equal sharing of the risk. If you negotiate both the price and band width at the same time, there is a high probability the price will be such that they will clearly make money at the worst point on the Band for them and all the Band will simply allow them to make more money. Negotiate the price in their local currency first, then convert it to dollars and then negotiate the bands.
  • The Buyer and Supplier could agree that if the currency changes more than a certain percent the price is subject to re-negotiation. This may not be good unless you limit the scope of the re-negotiation so you aren’t forced to give any more than the real impact of the currency.
  • They could agree that with certain currency changes either party may terminate the contract.

For the Buyer to pay the Supplier in the Supplier’s local currency without a great risk, the Buyer would either need to have what’s called a “natural hedge” where they are paying the Supplier in local currency that the Buyer earned in the Supplier’s country. If they don’t have local currency they will need to convert their money into the Supplier’s currency.

When you exchange currency there are two types of rates. A Spot Rate is the current day’s exchange rate. Currency options are traded just like other commodities where you can contract today to buy the currency in the future at the agreed price. This allows the Buyer to lock in a price today to purchase an agreed quantity of the other currency at the specific date in the future at set rates and not be subject to the spot rate at that time.  Options to buy currency in the future are what is called Forward Rate Contracts and you will find Forward Rates quoted in publications like the Wall Street Journal or the Financial Times.  Forward Rates are usually quoted in standard increments of: short term. seven day, thirty day, 3 month, six month and 12 month increments. 

When a Buyer purchases an option to buy the currency at a set amount in the future, by buying it at the forward rate, it eliminates the risk of currency exchange rate fluctuation. They have purchased the foreign currency at a fixed rate per the contract, not the spot rate, and they will be paying the Supplier in the agreed currency. When you hear the term “currency hedging”, all that means is the party is try to hedge the risk that can occur from currency fluctuations, and buying forward rate contracts is one example of hedging.

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