In today’s global economy, business leaders should consider sourcing and selling in foreign markets to grow their business. Whether your company is a subsidiary of a foreign company or a homegrown business looking to expand overseas, it is important to learn the alternatives to structuring foreign payments and receipts.
Here are some key considerations business leaders need to know in managing their company’s finances in a foreign country.
It’s important to address the question of whether you should you transact with foreign counterparties in U.S. currency or the counterparties’ local currencies. Many companies believe they can eliminate foreign exchange (FX) risk by conducting international transactions in their own currency. Unfortunately, the truth is that FX volatility risk between two currencies is always present. By transacting in their home currency, companies end up passing on the FX risk to their suppliers — many of whom will charge a premium for assuming the risk, or may fail to manage the risk appropriately. Transact in the foreign currency to avoid this and other problems.
What if you’re sourcing from a related entity, such as a parent company? It is still important to understand where the exchange rate risk lies, and which party to the transaction is best suited to manage it.
Consider a U.S. subsidiary of a German company that purchases all its inventory from the parent company. The U.S. represents 5% of the overall company, and the German parent sets pricing in U.S. dollars once per year. As the U.S. business manager, you may want to ask how the parent company is managing one year’s worth of exchange rate risk. Do they have a strategy in place to protect against market movement, or could pricing change if the market moves significantly? As only 5% of the overall business, this exchange rate risk may not be a priority for the German company, but it is a significant risk for the U.S. entity.
Second, companies who sell internationally may also prefer to accept payments from customers in U.S. dollars. However, accepting payment in foreign currency may open new markets with customers who don’t have the ability to make payments in anything other than their local currency. Plus, selling internationally in U.S. dollars means your products and services become more expensive in a stronger dollar environment, and you may run the risk of losing business to local competitors.
Once your international payments strategy is in place, the next step is to determine the appropriate type of foreign exchange transaction. FX transactions generally fall into two primary categories: spot and forward contracts.
A spot contract is a legally binding agreement to sell one currency and buy another on the nearest, standard settlement (value) date. This is a “buy now, pay now” deal at the current market exchange rate.
A forward contract is a legally binding agreement to buy one currency and sell another at a rate agreed upon today. Forward contracts are “buy now, pay later” products, which enable you to essentially lock in an exchange rate at a set date in the future. These involve two parties. One party agrees to “buy” later (taking the long position), while another party agrees to “sell” later (taking the short position).
As the FX market evolves, new solutions continue to be introduced. One recent innovation is a guaranteed FX rate program, which allows a company to maintain a monthly rate for all their FX transactions without having to specify dates and amounts.
An alternative approach to mitigating an exchange rate risk would be to open a foreign currency account. This is an ideal solution when a customer is selling and purchasing a product in the same currency. By using a foreign currency account, a company effectively protects itself from currency volatility for any amounts where the volumes of the receivables match the company’s anticipated payable needs.
With guidance and planning, you can decide how best to manage your out-of-country assets.
Editor’s note: Robyn Staggs is a senior relationship manager for global commercial banking at Bank of America Merrill Lynch in Northwest Arkansas. The opinions expressed are those of the author.