Although the World Bank recently predicted an unprecedented decline in international trade, the number of U.S. companies doing business overseas has actually increased in recent years. According to the Department of Commerce, American exports grew from approximately $1,017 billion in 2003 to almost $1,842 billion in 2008. Despite the opportunities that exist, some U.S. companies are still wary of overseas expansion given the domestic recession and increased volatility in foreign markets. The prospect of managing their exposures when converting foreign receivables to U.S. dollars may seem too overwhelming and complex.
Smart Business spoke with Hilary Love, a vice president in PNC’s foreign exchange group, about why U.S. dollar fluctuations have had such a profound impact on international markets. Love also outlines some of the risk management strategies U.S. companies can employ to shield against exchange rate risks while maximizing the benefits of doing business in promising emerging markets.
How have historic fluctuations in the U.S. dollar affected international trade?
As economies become more interdependent, the fluctuation in the value of the U.S. dollar has a bigger international impact. According to the U.S. dollar index, which measures exchange rates between the U.S. and six other countries, the dollar had its lowest recorded valuation in 2008. Over the past few months, the U.S. dollar has risen to 25 percent against many foreign currencies including some of our largest trading partners. This historic increase in the dollar is mainly due to the risk aversion that has taken hold of the markets.
The global economy has slowed and equity markets around the world have fallen, which has caused investors to move to more stable U.S. Treasuries. For instance, the euro depreciated more than 21 percent, the Canadian dollar was down more than 30 percent and the British pound fell more than 31 percent. Risk aversion will likely continue in uncertain times, which means the dollar should remain strong. For companies buying foreign goods or acquiring assets, this may be an opportunity to take advantage of these levels.
Why should companies entering foreign markets have risk management tools in place?
Financial flows are global in nature. Investment decisions made in one country can affect the currency of another country and can lead to disruptions in a domestic economy, based on the decisions fund managers or central bankers make in other parts of the globe.
For instance, because the United States is a large importer, U.S. companies paying overseas entities in U.S. dollars has resulted in an accumulation of large reserves of U.S. dollars overseas. Ultimately, overseas investors must decide if they want to keep the reserves in dollars or diversify into other currencies. By diversifying, overseas investors sell U.S. dollars in exchange for the desired foreign currency, putting downward pressure on the dollar, a trend that had been accelerating over the past several years before the global credit crisis. As global funds become more liquid, volatility in the U.S. dollar increases, impacting every entity doing business in the U.S. — through exchange rate movements and also domestic interest rates.
How can companies manage exchange rate risks?
If you do need to enter into transactions in non-U.S. dollar currencies, it’s important that you put hedging strategies into place. In addition to traditional forward contracts that simply remove currency fluctuation risk, there are other strategies that can both protect you against adverse exchange rate moves and allow you to benefit from favorable market movements. Most can be structured with or without an upfront premium payment and are also suitable for contingency situations where a forward contract isn’t appropriate. Here are a few of the more common options:
? An average rate option is particularly suitable when hedging a stream of payments. It’s similar to a standard option, except at maturity, the payoff is determined by the average of the spot rates during its lifetime, not the spot rate at expiration.
? A participating forward provides complete protection against unfavorable currency fluctuations, while allowing a company to participate to a degree in favorable currency movement.
? A range forward, or collar, enables a company to benefit from favorable rate movements while providing a definitive best- and worse-case rate.
All of these foreign exchange options can be structured to address your company’s specific circumstances, and many hedging strategies can be put in place with low-cost tools. Doing business in international markets may seem intimidating in light of recent events, but the uncertainty of the global economy underscores the importance of implementing a foreign exchange hedging policy.
This article was prepared for general information purposes only and is not intended as legal, tax, accounting or financial advice, or recommendations to buy or sell securities or to engage in any specific transactions, and does not purport to be comprehensive. Under no circumstances should any information contained herein be used or considered as an offer or a solicitation of an offer to participate in any particular transaction or strategy. Any reliance upon this information is solely and exclusively at your own risk. Please consult your own counsel, accountant or other adviser regarding your specific situation. Any views expressed herein are subject to change without notice due to market conditions and other factors.
©2009 The PNC Financial Services Group Inc. All rights reserved.
HILARY LOVE is a vice president in PNC’s foreign exchange group. Reach her at (215) 585-6334 or email@example.com. To learn more about currency risk management, check out PNC’s Advisory Series Web Seminar at pnc.com/joinus.