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Chapter 4:
Foreign Exchange Basics
Edward G. Hinkelman
International Payment 4th Edition
World Trade Press
Overview
In international commerce, payment for goods and
services usually involves the currencies of more than one
country, and the problem of which currency to use can
become a serious barrier to completing a deal.
There would be no problem if the currency of a seller's
country could always be bought and sold at a fixed and
invariable price compared to the money of a buyer's
country. However, in most cases, the relative value of
currencies is constantly changing, and some are quite
volatile.
Chapter 4: Foreign Exchange Basics 2
Overview
If the value of a currency changes between the time a
deal is made and the time payment is made it could have
a serious impact on the profitability of a transaction.
Example, if a trader has made a deal to be paid in a
foreign currency and that currency devalues before
payment is made, the trader will receive less value for the
goods than originally anticipated.
→ It is also true that extra profits could be made if the
foreign currency increases in value. In any event, this is a
risk most traders would prefer to avoid.
Chapter 4: Foreign Exchange Basics 3
Overview
There are many ways of dealing with foreign exchange
risk and the simplest, if you are the seller, is insisting on
payment in your own currency.
→ This strategy lays the risk at the buyer's door, but it may
not always be a viable option, and traders may have to
accept payment in foreign currency in order to make a
sale.
If full agreement cannot be reached, it may be possible
for both buyer and seller to share the risk by arranging
for a portion of the payment to be made in one currency
and the remainder in another.
Chapter 4: Foreign Exchange Basics 4
Overview
If it is absolutely necessary to take on the foreign
exchange risk, traders can protect themselves in a
number of ways. One way is to build the estimated cost
of a currency fluctuation into the deal to guard against
potential losses. However, as this is simply an estimate it
will rarely fully protect the trader.
Chapter 4: Foreign Exchange Basics 5
Using a Third Country Currency
While banks will undertake to assume the risk of currency
fluctuations under foreign currency letters of credit, they
do charge fees for this service (which can be hefty,
especially if a company conducts many smaller foreign
trade transactions).
Chapter 4: Foreign Exchange Basics 6
Using a Third Country Currency
Since it is unlikely that either buyer or seller will agree to
assume the risk of currency fluctuations, many
international trade transactions are invoiced in a strong
and stable currency—even if it is that of a third country.
For this reason the US dollar (US$), Euro and the
Japanese yen (¥) are all widely used in international
payments. In fact, more than half of world trade is
denominated in US dollars, although the Japanese yen is
widely used for trade throughout the Pacific Rim.
Chapter 4: Foreign Exchange Basics 7
Hedging
The management of currency in international transactions
is often accomplished through hedging. A hedge is a
contract that provides protection against the risk of loss
from a change in foreign exchange rates. There are three
common methods of hedging.
Chapter 4: Foreign Exchange Basics 8
Hedging
1. Forward Market Hedge
A trader can lock in the rate at which he can buy or sell a
foreign currency by buying, at the time the original sale
of merchandise (or services) agreement is made, a
forward contract to sell or buy that currency with delivery
set at the anticipated payment or receipt date.
Chapter 4: Foreign Exchange Basics 9
Hedging
2. Money Market Hedge
A trader can reverse a future foreign currency payment or
receivable by borrowing domestic currency now,
converting the currency into foreign currency at today's
exchange rate, and investing the proceeds in foreign
money market instruments.
The proceeds of the money market instruments upon
maturity can be used to meet the foreign currency needs
payable at that date.
Chapter 4: Foreign Exchange Basics 10
Hedging
3. Options Market
There are two types of foreign currency options available
to manage risk.
A "put" option gives the buyer the right, but not the
obligation, to sell a specified number of foreign currency
units to the option seller at a fixed dollar price, up to the
option's expiration date.
A "call" option, on the other hand, is the right, but not
the obligation, to buy the foreign currency at a specified
dollar price, at any time up to the expiration date.
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Hedging
Risks of Hedging
While hedging can reduce a trader's exposure to
foreign currency fluctuations, the costs of such
instruments must be balanced against the risk of loss.
Their usefulness is also limited by the fact that they are
only available for major currencies and for certain
maturities, which makes their use difficult for traders
with substantial exposure in developing countries.
However, since most trade is conducted in the major
currencies for which options are available, and many
international payment terms are consistent with the
maturity terms of currency hedging instruments, they
are usually a viable alternative.
Chapter 4: Foreign Exchange Basics 12
Hedging
Costs of Hedging
For a trader that has frequent exposure in many currencies,
hedging every transaction is counterproductive, since the
likely outcome of the gains and losses under an unhedged
position will approach zero.
Unless the exchange market is perceived to be grossly
distorted due to undue government intervention or some
other reason, a policy to hedge all exposures is likely to be
as costly as the expected exchange rate changes.
If hedging a large number of transactions will produce the
same outcome as the unhedged position, then the overall
gain from hedging operations is slightly negative because of
the cost of arranging the protection.
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Hedging
Hedging Risks for Buyers
Since most traders prefer to avoid the risk of currency
fluctuations, they usually shift the foreign exchange risk
to commercial banks.
If a buyer arranges to establish a letter of credit in the
seller's country, the payment to such seller will be
made in the seller's own currency by a designated
overseas paying bank in the seller's country.
Upon receiving the documents from the opening bank
in the buyer's country, the buyer is required to supply
domestic currency equal to the amount of foreign
currency paid by the overseas bank.
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Hedging
Hedging Risks for Buyers
If the conversion of currency occurs on the same day as
payment is made, it is usually based on the exchange
rates of the two currencies on that day.
The buyer's bank just sells the foreign exchange to the
buyer at that day's rate—called the spot rate—and credits
the foreign exchange account of the overseas bank.
Chapter 4: Foreign Exchange Basics 15
Hedging
Hedging Risks for Buyers
If the buyer wishes to eliminate any unfavorable
exchange risk arising from currency fluctuations
between the time the buyer arranges to open the credit
and the date of actual payment, the buyer can arrange
with the domestic bank at the time the letter of credit
is opened to execute a forward exchange contract.
→ The buyer knows the exact cost in dollars in time for
the actual payment, and any exchange risk is assumed
by its bank.
Banks are better positioned to assume such risk as
many have active foreign exchange management
departments.
Chapter 4: Foreign Exchange Basics 16
Hedging
Hedging Hints for Sellers
If a seller receives a letter of credit in a foreign currency
the seller may arrange with the local advising bank to sell
the foreign currency to be realized upon payment.
In this case, the risk of exchange is assumed by the
seller, since the conversion of foreign currency into local
currency will be made at the rate of exchange on the day
the seller executes the exchange contract with its bank.
Chapter 4: Foreign Exchange Basics 17
Hedging
Hedging Hints for Sellers
To avoid any risk of foreign currency devaluation on the
date of transaction, the seller should consider borrowing
the same foreign currency for the duration of the
outstanding transaction and selling the loan proceeds at
the current rate for the local currency.
At the time of payment by the foreign bank, receipt of
foreign currency will repay the borrowing. By immediately
selling the loan proceeds at the outset for domestic
currency and placing them on time deposit, the ensuring
interest yield will reduce the gross borrowing expense.
Chapter 4: Foreign Exchange Basics 18
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