Managing Foreign Exchange Risk

By Michael C. Dennis

In international export sales transactions, buyers and sellers often deal with the challenge of using different currencies, and the relative values of these currencies can be highly volatile, constantly fluctuating. Consequently, exporters must make a critical decision regarding whether to demand payment from foreign buyers in 'their' current, in the buyer's currency, or in another currency, such as the Euro or the Yen.

Depending on whether the sale is quoted in the buyer's currency or the seller's home currency or a third currency, either the buyer or the seller may face additional expenses or potential losses if the exchange rates between these currencies change between the sale and the payment settlement. Consequently, the decision to accept payment in a foreign currency introduces an element of risk to the seller's profit margin.

Most U.S.-based exporters, therefore, prefer their sales to foreign customers to be invoiced in U.S. dollars and settled in the same currency. (Similarly, buyers typically prefer to be invoiced in their own national currency rather than in U.S. dollars for the same reasons.)

Foreign exchange rate fluctuations represent a significant risk when companies are engaging in international trade. In response, some companies assign their credit managers the task of not only monitoring but also actively managing this type of risk. Various methods are employed to mitigate foreign exchange risk.

One straightforward approach involves adding a margin to the invoice price to account for potential foreign exchange rate fluctuations. Alternatively, a contractual arrangement can be established between the buyer and the seller, often referred to as a "currency window." A currency window acts as a mechanism through which both parties share the risk associated with substantial fluctuations in foreign exchange rates.

Another technique for managing foreign exchange rate changes is hedging. Hedging involves using financial instruments to transfer a portion or the entirety of the foreign exchange-related risk away from the seller. However, it's important to note that hedging is a complex strategy that demands expertise, and there are costs for the company engaging in the hedging activities.

Summary:? In international export sales, currency differences and volatile exchange rates create challenges. U.S. exporters must choose between foreign currencies and U.S. dollars for payment, potentially affecting profit margins due to currency fluctuations. Most U.S. based companies prefer invoicing and payment in U.S. dollars. ?If they accept payment in other than US dollars, these companies often use strategies like adding margins to invoices, currency windows, or hedging to manage exchange rate risks.

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