Managing volatility in foreign currency exchange Featured

10:35am EDT March 1, 2012
Managing volatility in foreign currency exchange

Volatile exchange rates have become a permanent fixture of the post-2008 financial markets, turning a foray into the global marketplace into a fiscal roller coaster ride. Instead of reducing risk by locking in exchange rates from the outset, companies face uncertain profitability, cash flow and market value when they attempt to time transactions to capitalize on favorable exchange rates.

“You don’t have to put your hard-earned profits at risk to compete in the global marketplace,” says Doug Reichman, corporate foreign exchange advisor for California Bank & Trust. “You can enhance your competitive position and overcome vacillating currency values by utilizing foreign exchange services.”

Smart Business spoke with Reichman about managing currency exchange exposure by utilizing foreign exchange services.

What is foreign exchange exposure and how does it impact profitability?

Companies want to grow their top line by selling products and services overseas, but unless they solidify the currency exchange rate, the price and margin may go up or down each time an invoice is processed. If you buy parts overseas, manufacture in the U.S. and sell finished goods to a company in a foreign country, it’s difficult to forecast sales and profitability given the number of currency exchanges that occur over the course of a transaction. Executives often try to avoid volatility by demanding payment in U.S. dollars, but savvy competitors who deal in foreign currency have a distinct advantage in overseas markets.

How can business leaders identify foreign exchange exposures and opportunities?

You need to forecast sales and profits using a variety of exchange rates and scenarios to recognize and exploit the arbitrage. For example, if you plan to ship $1 million worth of goods to France in three months, you need to look at the current exchange rate and the recent swings to see what you may ultimately collect. In the process of reviewing the best and worst case scenarios, you may recognize an opportunity to manage risk or find that selling products in Asia is more profitable than Europe.

What constitutes an effective hedging strategy?

Effective strategies are customized, mitigate currency exchange risk and help the company achieve its financial goals. The challenge is that most companies don’t have the time or expertise to develop and execute an in-house strategy that relies on precise calculations, great timing and luck to balance gains and losses. For example, some executives try to protect their margins by paying early or late for products, depending on whether they expect the exchange rate to rise or fall in the future. Still others hope that gains and losses balance out over time, but that approach is a gamble in a volatile currency market.

How can a currency advisor help?

Whether your goal is to increase sales, enter new markets, protect profits or improve supplier relationships, a currency advisor has the expertise to help you meet your objectives. First, he’ll review your budget and understand your objectives; then he’ll trace every dollar to expose the risks and opportunities that occur during currency exchanges over the course of the business cycle. Finally, he’ll recommend a hedging strategy and customized suite of services so you can focus on your core business instead of monitoring the hourly swings in the foreign currency market.

Which banking services are most effective for controlling risk and why?

While banks offer many types of foreign exchange services, businesses often use the following products to facilitate profitable global commerce.

? Spot contracts: A simple way to handle payables and receivables in a foreign currency. Currency is converted based on the current rate, funds are wired and your account is credited or debited within two days.

? Forward contracts: Allow you to secure an exchange rate now for a specific settlement date within the next 12 months. Whether you’re buying or selling a piece of equipment, both parties are protected from swings in the exchange rate when the deal is settled.

? Window forward contracts: Essentially the same as a forward contract, except the settlement date is flexible in cases where the manufacturing process or product delivery date hinges on uncertain factors.

? Vanilla currency options: Like insurance, a currency option allows you to exchange currency at a pre-agreed rate on a specific date for a fee, providing protection in case the market moves against you.

? Demand-deposit accounts: Allow you to hold foreign currency and use it to pay employees or bills without exchanging the money to U.S. dollars.

Do you have any other tips for executives venturing into the international marketplace?

First, understand your financial objectives before you engage in international commerce. Develop a forecast and budget and consult with a qualified professional to ensure that your goals are realistic and achievable. Second, understand the exposures and don’t take unnecessary risks, because speculators can get burned in today’s foreign currency market.

Finally, talk to your banker before you make any decisions. Your banker can explain foreign exchange products in simple terms and recommend a strategy and portfolio of services to help you meet your business objectives. There’s no need to put your profits at risk, when your banker has the knowledge and tools to help you succeed in the international marketplace.

Doug Reichman is corporate foreign exchange advisor for California Bank & Trust. Reach him at doug.reichman@calbt.com or (213) 593-2113