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Ask About Foreign Exchange Risk

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By | May 25, 2012

Dear Toolkit,

Our fairly young small business is branching out by selling our product in other countries. How can we protect ourselves against a loss of profits due to fluctuations in currency exchange rates?

Thanks,

Nervous Novice

Dear Nervous,

Congratulations on your expansion into the lucrative and exciting world of foreign trade. And kudos to you for realizing that it can be a lot less lucrative and far too exciting should you fall victim to foreign exchange rate whiplash.

Next to not doing business abroad at all, your best defense against foreign exchange rate loss is to conduct all business in U.S. dollars. Requiring your overseas clients to pay up in dollars puts the onus of currency fluctuation on the buyer and completely insulates you from any shrinkage of profits from exchange rate differences.

But—oh, yes, there's that ubiquitous "but"—such a policy may also insulate you from getting any customers at all since your more experienced competitors are likely to be a bit more sensitive to the buyer's real (or even imagined) needs.

If your competitors are invoicing in the customers' domestic (for them, foreign for you) currencies, you'll have little choice but to do likewise. Fear not—as long as you understand the risks associated with this practice, you can manage them more stoically.

Risk numero uno is economic—that your costs will rise due to changes in rates and make your product uncompetitive in the world market in general. There's not much you can do about economic risk. It's just a normal business risk everyone must endure.

Then there is transaction risk—that there will be an unfavorable move in a specific currency between the time you quote a contract to the time it is completed. In this case, you could certainly require payment in advance of shipping, but like insisting on payment in U.S. dollars, this practice could put you at a severe competitive disadvantage. If nobody else is requiring advance payment, who would choose to do business with you?

Larger exporters often stem transactional exchange rate problems by factoring. They transfer title to their foreign accounts receivable to a factoring house that assumes responsibility for collections, administration, paper pushing and any other service the exporter chooses.

There is, of course, a fee involved for these conveniences. The fee is generally expressed as a discount rate on the value of the receivables—say five or 10 percent, or more. So the exporter may sell his receivable to the factor for 90 cents on the dollar, for example, having hopefully built that 10 percent cost into his selling price.

Another way to stem transactional exchange rate problems is by hedging. This involves the use of options trading and requires a lot of experience in currency markets. Larger companies use it routinely. I don't recommend it for a nervous novice!

Perhaps you should consider being more concerned about what are known as commercial and country risks.

Unlike exchange rate risks, these can actually be insured, as long as you're willing to pay the increased costs. Commercial risks might include the default or bankruptcy of the buyer. Country risks are political, and include war or unilateral currency restrictions that might be imposed in less stable nations.

This kind of insurance is pretty pricey on the private market, but our government operates an Export-Import Bank (Eximbank) that is trying to become more helpful to the small exporter's insurance concerns. This program allows a small exporter to be more aggressive in selling to foreign markets, thus helping to balance the trade deficit we hear lamented so long and loudly.

Getting back to your original question: Clearly, the need to control the risk of lower profits due to currency exchange rate volatility is offset by the need to stay competitive; like most of life—it's a trade-off.

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