A working knowledge of the fundamentals of foreign exchange and foreign currencies is helpful to both individual travelers and American finance managers doing business abroad. The goal for individuals is usually to protect daily purchasing power, while the goal for American companies may involve complex exchange risk and hedging strategies.
Who amongst us has not returned from a foreign country with unusable foreign bills and coins? A simple frequent traveler tip may help. While you might be wary of smaller airport kiosks and booths as a venue for exchanging currencies, very often these locations really do provide the best available exchange rates – and better than many commercial banks. Why? Because these kiosks usually handle a far higher volume of business, and therefore they can afford to be ‘truer’ to daily fluctuations in exchange rates. Often the best bet is to stop at the high-volume airport booth (either in the foreign country or in the US) before heading home, because less active metropolitan banks and/or suburban branches are often also less competitive in both rates and in the time it takes to convert your cash. Also, many bank lobbies will not even accept some lesser-known currencies.
When getting familiar with another country’s currency, it important to keep in mind that the daily foreign currency exchange rates which are posted on the Internet, in the Wall Street Journal or elsewhere are usually reserved for the largest ‘paperless’ or digital transactions involving a million or so units of the currency. Some smaller transactions, including trades in bank lobbies, will usually be priced at rates 1-15% worse than the published rates for major or preferred customers. The larger your transaction is, the more likely that a major commercial bank and/or a designated foreign currency trading operation will offer more favorable rates.
Foreign Exchange Forward Contracts Can Be Used to Hedge Company Risks
American businesses which are exploring foreign import and/or export activities can help themselves by familiarizing themselves with a few simple but lesser-known aspects of the foreign currency world. This can be especially valuable on new export sales when deciding whether to invoice in US Dollars or in the buyer’s foreign currency.
One of the key determinants of the exchange rate between any two countries is the interest rate differential between the two countries. If the foreign country (Germany, for example) has lower base interest rates than the US, their currency is said to trade at a ‘premium’ as compared to the US Dollar. Thus, it can be a profitable decision for the American company to invoice its export sales in Euros (or any of the other so-called ‘premium’ currencies) rather than Dollars, especially if the agreement with the foreign buyer is for delayed payment, say in 30-180 days. While invoicing in foreign currencies and accepting delayed payment are usually important credit underwriting decisions to be made very carefully, an American company invoicing in Euros and expecting payment in 180 days can actually ‘sell the forward Euros’ to its bank and receive slightly more Dollars today. This is because of the embedded mathematics inherent in the Euro and Euro bloc countries which currently have lower interest rates than the US.
In a sample case of an American exporter selling to Germany under a 1,000,000 Euro Invoice and expecting payment from abroad in 180 days, the US exporter can actually sell those ‘forward Euros’ today in advance to his US bank and receive approximately 1,010,000 Euros immediately. These ‘premium’ amounts will differ from time to time. By converting the Euros instantly to Dollars, the company can thus realize the triple benefits of immediate cash, a slightly higher profit margin, and also a hedge against future exchange risk. Obviously, the American company is still responsible for collecting the foreign receivable and German customer must still make the payment on time 180 days down the road. But assuming that collection is not an issue, an American Treasurer or Finance Manager’s ‘forward sales’ of reliable Euro remittances can be used to enhance current profits for his company. This concept of ‘selling a forward receivable’ immediately in order to enhance profits and to protect against currency price fluctuations can be one important element in an American company’s overall foreign risk hedging strategy.