https://www.jeffharbaugh.com/wp-content/uploads/2014/08/logo_color_640.gif 0 0 jeff https://www.jeffharbaugh.com/wp-content/uploads/2014/08/logo_color_640.gif jeff1995-06-13 04:49:482014-09-28 11:35:44Foreign Exchange Management; What’s All This Brouhaha?
Actually, there’s nothing to it. The differential in rates of inflation between the economies of two countries equals the percentage change in the exchange rate over the same period. This is known as the Purchasing Power Parity theorem.
There. That should be clear. Of course, government intervention in the markets can also affect exchange rates and everybody knows that in the short term currencies with higher interest rates tend to be stronger, but of course the dollar has plummeted recently following a series of short term interest rate increases by the Federal Reserve, and various tariffs and trade barriers affect rates, so I guess that’s not always right.
What we really ought to do is read the 78 pages of fine type in Financial Accounting Standards Board pronouncement 52 that deals with accounting for foreign exchange transactions. Then this wouldn’t be so confusing.
On the other hand, we could say screw it. Unless we’re buying or selling in a foreign currency or, as a retailer, have a lot of time, effort and money invested in establishing and promoting a brand you’d like to see survive and offer better prices. Or unless you’re making boards (or other products) in the U.S. and exchange rates affect how your competitors price their products. Or unless you’re exporting boards and getting paid in a currency besides dollars.
The hypothetical U.S. based company BFD Snowboards is buying boards from that European snowboard manufacturing behemoth EPS. BFD is only buying 5,000 boards and EPS’s capacity is sold out, so they can insist that BFD pay for the boards in their currency. Let’s let our imaginations run wild and assume it’s the German Mark.
In spring, BFD opens a letter of credit (LC) through their bank in favor of EPS. Let’s say all 5,000 boards are the same and each costs 200 Deutsche Marks (DM 200). This board is hot. All 5,000 are committed to dealers (must be a signature board). BFD’s letter of credit is for DM 1,000,000 (5,000 times 200).
That’s as complicated as we’ll let this example get. In practice, partial shipments up to the total of the LC may be permitted, EPS may be allowed be over or under the DM 1,000,000 by maybe 10%, and some of the boards shipped may be second quality boards that carry a lower price. In addition, assuming BFD is buying ex factory (that is, they are responsible for all the costs after the boards leave the factory door) they will spend six to seven percent of the purchase price in freight (more if it’s air freight) and customs duty to get the boards to the U.S.
What these variables mean is that the actual DM amount you have to pay may be higher or lower than 1,100,000 and there may be more than one payment date.
The LC is opened in April. An LC, for those of you who have had the good fortune not to have to deal with them, is a promise made by a bank to pay a certain amount of money upon receipt of specific documents indicating shipment of the correct merchandise the right way, by the time required. Note that the bank pays based on the documents. There’s no protection against fraud. If the boxes get to BFD and are full of P-tex scraps, the bank has no liability if the documents they paid against were as required.
In April, then, BFD has a potential liability for DM 1,000,000. It doesn’t become an actual liability until EPS ships the product. If the exchange rate at the shipment date is, say, 1.60 DM to the Dollar, BFD will have to come up with $625,000 (DM 1,000,000 divided by 1.60) to pay for the merchandise. That payment date depends on the terms of their agreement with EPS.
Assuming it costs them about DM 12 for freight and duty, BFD’s landed cost for each snowboard is DM 212, or $132.50 at the exchange rate in effect when the LC was opened. Now BFD wants to earn a little money itself to pay for lift tickets, so it marks the product up and sell it to retailers for $172.25, giving BFD a gross profit of $39.75, or 30 percent.
Ah, but we forgot about that moving exchange rate. BFD had to price their boards before the letter of credit was ever opened so retailers could show up at the shows and know what they were going to pay for it. If, at the time BFD set their prices, the exchange rate was 1.70 DM to the Dollar, BFD is bummed. As the Mark has strengthened from 1.70 to 1.60 (strengthened because you get fewer Marks for each Dollar) BFD’s dollar cost per board has risen from $124.71 (DM 212 divided by 1.70) to $132.50 (DM 212 divided by 1.60). If, on the other and, the Mark was at 1.50 when BFD set its prices, it is mighty happy, because its dollar price per board has declined from $141.33 (DM 212 divided by 1.50) to $132.50 (DM 212 divided by 1.60).
The difference between a cost of $141.33 and $132.50 is 6.25%. To put that in perspective, it’s enough to be the difference between a profit and a loss for the year. For BFD, it’s a swing in gross profit of $44,150 on the sale of the 5,000 boards.
Exchange rates move every day. A lot, a little, up, down; there’s no way to tell. If BFD just waits until they have to pay EPS marks, it will have to pay whatever number of dollars the market dictates at that moment. That’s one possible strategy. There a couple of others.
At any time you can buy the marks you need and put them in a bank account in Germany earning interest. The marks will be available to pay EPS as required, and you will know your exchange rate and, therefore, your cost.
Choice two is to buy a forward contract. A forward contract is an agreement entered into with a third party, usually using a financial institution as an intermediary, to buy or sell a given amount of foreign currency at an agreed upon exchange rate on a specified date. Forward markets for major currencies are broad and deep. You can generally buy or sell whatever amount you need for delivery at the date required. The forward rate (that is, the exchange rate at which you buy or sell a currency for future delivery) is determined by market expectations.
BFD is buying DM 1,000,000 of boards from EPS. Let’s say EPS ships the boards May 15. The documents from the shipment go to EPS’s bank and then to BFD’s bank to be “negotiated.” The letter of credit calls for terms of “sight 60.” That is, BFD’s bank, and therefore BFD is required to pay DM 1,000,000 60 days after documents receipt. If the documents are received May 23, payment date would be July 23rd.
BFD decides the dollar is as strong as it’s going to get before payment is due and that, in any event, it doesn’t like it’s profitability to depend on the whims of an unpredictable market. It instructs its bank to purchase forward DM 1,000,000 for delivery on July 23rd. The bank enters into the contract and BFD now knows exactly what those boards will cost it. It no longer cares how the Mark moves against the Dollar between now and July 23rd. It’s cost in dollars will be the same.
On July 23rd, BFD receives the marks, paying dollars for them at the contracted exchange rate, and orders its bank to transfer the marks to EPS’s bank account to satisfy its liability to EPS. Depending on how the dollar and mark have moved against each other in the period between the date the forward contract was purchased and the date it matured, BFD’s financial manager may feel like a hero or an idiot. But a major source of financial risk will have been removed.
The third option involves what’s called asset liability management. Let’s assume BFD doesn’t really know anything about the U.S. market, but has convinced some Japanese distributor that it is a cool brand and that Japan really needs another snowboard (obviously, this is a hypothetical situation.). The Japanese distributor agrees to buy 4,000 of the boards, to pay for them in German Marks at a price of DM 250 per board, and that payment is due July 23, the same date BFD must pay EPS.
Suddenly, BFD has a perfect balance sheet hedge. They have an asset of DM 1,000,000 they will receive from the Japanese distributor and a liability, due the same day, to EPS. They no longer care how the dollar moves against the mark because they will not have to convert one currency into the other.
If you’re exporting and getting paid in a foreign currency, the problem is the mirror image of paying for imports in foreign currency. Most companies I know of solve this problem by insisting on payment in dollars.
Now you know a little about how foreign exchange risk arises and how it can be managed. You may also have realized that even if you don’t deal in foreign currencies, your suppliers and/or competitors probably are. That affects the prices you pay and the profit you can make and is worth a few minutes of thought.