Updated: Sep 25, 2020
Understand the risks and opportunities associated with trading foreign currencies
When a company does business internationally and buys or sells goods in a different country, it will either pay for purchases in the foreign currency or earn income from sales in the foreign currency. Exchange rate risk becomes a factor in these interactions because the value of the foreign currency could change between the time of the transaction and the time payment is made or received and converted to the company’s home currency. A lag of 30 to 90 days in accounts payable is fairly common, so global companies often have at least a 30-day window when fluctuations in exchange rates could result in paying or earning more or less than they planned on.
Global firms seek to reduce or even eliminate this exchange rate risk by adopting one of three common strategies: spot rate exchanges, a hedge, or a currency swap. Let’s take a look at each one of these strategies.
Spot rate exchanges allow a firm to buy the needed foreign currency (at the so-called “spot rate”) at the time of the transaction. This eliminates the time gap between agreeing on a price and making the payment. For instance, if Hyundai Motors of Korea were to agree to buy rubber from Salim Ivomas Pratama, an Indonesian rubber company, Hyundai could simultaneously sign the contract and buy Indonesian Rupiah to pay Salim even if the payment were not due for a few weeks. This way Hyundai would remove the risk of the Rupiah gaining value relative to the South Korean Won in the intervening period.
The next strategy used in managing foreign exchange risk is a hedge. Hyundai could hedge its foreign exchange risk by agreeing with a bank to buy an option that would allow it to purchase a set amount of Rupiah at a set price in 30, 60, or 90 days. Agreeing to the price for the Rupiah ahead of time allows Hyundai to transfer any exchange rate risk to the bank. This type of transaction is called a forward contract. In essence, it takes the future exchange rate and shifts the risk to the bank for a fee. Another type of hedge called an “option contract” lets Hyundai purchase Rupiah at an agreed upon rate in the future, but Hyundai is not required to buy the foreign currency if the previously agreed-upon rate is worse than the rate the company can get on the open market. For instance, if the Rupiah becomes less expensive in the period, Hyundai can use the current spot rate to purchase Rupiah when its payment is due and pocket the difference. Hyundai pays the bank for the option whether it exercises it or not, but buying the option removes the company’s downside risk.
The third strategy global firms use to manage foreign exchange risk is a currency swap. With a currency swap, two global firms borrow money in their local currency and then swap the principal with the other party. For instance, if a British company needs Brazilian Real and a Brazilian company needs a similar amount of British Pounds, the British company could borrow pounds while the Brazilian company borrows Real. Then the companies swap their currencies, giving each company the foreign currency it needs but allowing each company to pay back the loan in its local currency, eliminating exchange rate risk.
These three strategies help mitigate the risk of doing business internationally with foreign currency.