Up until now, the euro has been going through a multi-year phase in. Come Jan. 1, the European Central Bank will introduce some 15 billion banknotes and 56 billion coins to the Eurozone, which includes Belgium, Germany, Spain, France, Ireland, Italy, Luxembourg, the Netherlands, Austria, Portugal, Finland and Greece.
All the different national, or “legacy,” banknotes and coins of Eurozone members will start being withdrawn from circulation at that time and all scriptural transactions will be required to be denominated in euro.
So how can West Michigan companies doing business overseas minimize their foreign exchange risk and take advantage of the euro?
That was the focus of a Fifth Third Bank seminar, conducted earlier this month at the Van Andel Global Trade Center by Donald Lloyd, Fifth Third vice president and foreign exchange manager for the Chicago region, who discussed currency exposure, financial risks and hedging strategies.
Getting Europe together as a group lowers currency rates and encourages competition, but the biggest benefit of the euro conversion is that it makes Europe a larger trading partner, Lloyd said.
The foreign exchange, or FOREX, market is the largest financial market in the world, with daily trading volumes upwards of $1.3 trillion. Its volatility is not only unpredictable, but sometimes extreme; any economic, political or psychological news can move it.
“It’s all about making informed decisions,” Lloyd said.
For a U.S. company, foreign exchange exposure results from any transaction in a currency other than the company’s functional currency, Lloyd explained. Companies that have non-U.S. dollar (USD) receipts or payables have currency exposure. But even if a company doesn’t have non-USD receipts or payables, it still has economic and competitive risks, he said.
Among the most common risks Lloyd discussed:
- Transaction risk, which is the risk of depreciation in a foreign currency receivable or appreciation of a foreign currency payable versus the USD. For example, the euro revenue received through the sale of a product could depreciate against the USD.
- Translation risk, which is the risk from consolidation of a foreign subsidiary’s financial statements to the U.S.
- Competitive risk, which is the risk of price competition with a foreign competitor. For example, a foreign competitor ships product to the U.S., picks up USD-denominated sales and bases costs in euros, then lowers prices to take market share.
- Economic risk, which is the exposure produced by doing business in a non-functional currency over a long period.
- Contingent risk, which is a fixed price bid-to-award currency risk. If there’s a currency rate change, for instance, a contract negotiated today in some foreign currency may not be worth the same 60 days later when it’s actually signed.
As Lloyd pointed out, there are several strategies companies can use to hedge those risks.
Spot contracts, which exchange currencies at today’s rate, don’t involve hedging. Generally, spot deals are settled two business days after the contract date. But spot contracts can be risky because they’re subject to the whims of a volatile currency market, Lloyd said.
Forward contracts, the most common form of currency hedging, are contracts paid for when they come due. A company negotiating a forward contract locks into the exchange rate in advance, anywhere from three days to five years, thereby eliminating any upside potential or downside risk. A forward contract fixes costs and is the most risk-free form of hedging, Lloyd noted.
An option contract can be negotiated for larger deals of $250,000 or more. An option contract gives a company the right to execute a trade at a given rate when the contract matures, so it guarantees a specific rate or, potentially, a better rate. Options also can be sold in the market prior to their expiration date.
Similar to buying insurance, this kind of contract requires payment of an up-front premium. This kind of contract has unlimited profit potential and limited downside risk.
“Option contracts basically give you the right to sell and buy a currency,” Lloyd explained. “You buy the right as you would an insurance policy to hedge yourself. You don’t have to use it, but it’s there if you need it. If you’re going to shop options, ask what the volatility is.”
Lloyd has more than 20 years of experience in the Foreign Exchange market, including serving as president of FOREX USA from 1997 to 2000, during which time he also was a member of the Federal Reserve Foreign Exchange Committee.
Fifth Third Bank has a large foreign exchange trading desk, one of the largest in the Midwest, and recently began offering international trades around the clock with the introduction of 24-hour access to Fifth Third FX Internet Trading.