by Laurie Schwager
In today’s global economy, businesses should consider sourcing and selling in foreign markets for growth. Whether your company is a subsidiary of a foreign company or a US-grown business looking to expand overseas, it is important to learn the alternatives to structuring foreign payments and receipts.
Managing overseas financial transactions is no easy feat.
Currency exposure, pricing, foreign bank services and other risks may leave you feeling overwhelmed. Here are some key considerations for managing your company’s finances in a foreign country.
Should you transact in U.S. currency or the foreign counterparties’ local currencies?
First, it’s important to address the question
of whether you should 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.
Bank of America Merrill Lynch suggests considering transacting in the foreign currency to avoid this and other problems. Here are some benefits associated with purchasing in local currency instead of U.S. dollars (USD):
■ Reduce costs: When a supplier invoices in USD vs. local currency, the supplier assumes all of the exchange rate risk and may increase their prices in USD to protect themselves from currency market movement between the invoice and payment date.
■ Visibility into FX rates: Obtain competitive exchange rates from your bank and know the exact amount of foreign currency paid to suppliers.
■ Negotiate more favorable payment terms: Payments in foreign currency typically have faster credit posting to beneficiary accounts.
What if you’re sourcing from a related entity, such as a parent company? In that case, it is still important to consider where the exchange rate risk lies and which party to the transaction is best suited to manage it.
For example, consider a U.S. subsidiary of a German company that purchases all its inventory from the parent company. The U.S. represents five percent of the overall company, and the German parent sets pricing in U.S. dollars once per year. As the manager of the U.S. business, you may want to ask how the parent company is managing one years’ 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 five percent 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.
Bank of America Merrill Lynch suggests discussing these factors with your suppliers, related or external, and revisiting it regularly, to avoid a shock to your business from an unforeseen market change.
International companies may prefer payments in U.S. dollars
Second, companies who sell internationally may also prefer to accept payments from customers in U.S. dollars. Accepting payment in foreign currency, however, may open up new markets with customers who don’t have the ability to make payments in anything other than their local currency.
Plus, selling internationally in USD 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.
The next step
Once your international payment 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.
■ Spot contract: A spot contract is a legally binding agreement to sell one currency and buy another on the nearest, standard settlement (value) date. In other words, this is a ‘buy now, pay now’ deal at the current market exchange rate. According to Trade Global Financial, some benefits of spot contracts include easy operation, 24-hour trade access and zero deposit requirements.
■ Forward contract: A forward contract is a legally binding agreement to buy one currency and sell another at a rate agreed upon today. In other words, 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’ at a later date (taking the long position), while another party agrees to ‘sell’ at a later date (taking the short position). The advantages of forward contracts include choosing a rate which is acceptable for your business and managing and budgeting cash flow without worrying about future FX volatility.
As the FX market evolves, new solutions continue to be introduced. One recent innovation is the introduction of a guaranteed FX rate program.
A spot rate is based on the prevailing market rate two days before settlement, and a forward rate is based on the prevailing market rate for a specific FX amount and settlement date in the future. What if a company would like visibility over their FX rate for future transactions but doesn’t know the exact date the FX payment will be sent or received? A guaranteed FX rate allows a company to have a monthly rate for all their FX transactions without having to specify dates and amounts.
New solutions like the guaranteed rate will continue to make global business easier to execute.
An alternative approach
Finally, 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.
When opening a foreign currency account, however, it is important to determine whether the volume and transaction activity outweighs the fees associated with a foreign currency account. A disadvantage of this approach is that a company ties up liquidity, as funds would be held in a foreign currency until later need arises.
A financial advisor or bank partner can help you and your company expand globally. With guidance and planning, you can decide how best to manage your out-of-country assets.
LAURIE SCHWAGER IS A SENIOR RELATIONSHIP
MANAGER AT BANK OF AMERICA MERRILL LYNCH.