International payments arise in a host of situations in a global economy. A U.S. company acquires equipment, raw materials, products, or services from overseas; a manufacturing facility in a foreign country requires cash transfers between it and the U.S.-based parent company; revenue coming in from an overseas subsidiary denominated in the foreign currency has to be converted; and payments have to be made to a foreign contractor or bank.
But many U.S. organizations manage international currency payments in a way that unnecessarily increases the cost of the products or services they import from overseas, and it puts them at a significant disadvantage when competing internationally. In particular, there are two commonly held beliefs in international trade that are costing U.S. companies billions of dollars annually.
The first misconception is that dealing in U.S. dollars effectively mitigates foreign-currency exposure. The U.S. dollar is the international payment currency of choice, no doubt. From the most recent Bank for International Settlements Tri-Annual Survey, the U.S. dollar is involved in more than 80% of international payments executed each year. While the acceptance of the U.S. dollar internationally makes it a popular option for facilitating transactions, the convenience often comes at a high price.
Since organizations on both sides of an international payment generally have a strong “bias” toward holding their own currency, the foreign counterparty generally converts U.S. dollars received into its native currency. But transferring responsibility for the currency conversion (if you are the payer) to the foreign counterparty does not amount to managing the risk. In fact, the opposite is often true. The international counterparty will build in not only an estimated fee for the currency conversion but also a premium to compensate it for a potential adverse change in the exchange rate. The premium assigned by the international counterparty for receiving U.S. dollars amounts to a hidden cost for the customer and can be a substantial percentage of the overall transaction.
Here’s an example of how one U.S. company handled this problem.
The company needed to pay a vendor in Europe $1 million. Historically, it had been unconcerned with the foreign-exchange risk, as its practice was to require payments to be made or received in dollars. Having not looked beyond the dollar side of the transaction, the company had no idea how much of a premium was built into the $1 million amount to account for the vendor having to convert the payment into euros.
We recommended the company request the European vendor invoice it in euros, in the hope of discovering the amount of the penalty assessed for paying in dollars. The vendor willingly replied it would accept €705,000. This occurred in October 2011, on a day when the dollar-toeuro exchange rate was 1.38; therefore, €705,000 could be purchased for $972,900. The vendor had clearly built in a cushion of $27,100 (2.7%) into the product price.
By paying in euros, the vendor’s native currency, the U.S. company stood to save $27,100 and the vendor would receive its preferred method of payment, euro. Savings of this magnitude can result in a significant reduction in a product’s cost.
Timing Does Not Equal Speculating
The other commonly held belief in international trade that is costing companies money is the notion that leveraging market information to estimate an appropriate time for a foreign-currency transaction automatically equates to speculating in the currency.
It is true that no one can predict with certainty in which direction a financial market will move. Even experienced foreign exchange traders or analyst employing the most sophisticated fundamental and technical market analyses will often be wrong in their projections of future currency prices. With that said, timing of a transaction can make a significant difference when done in conjunction with a well-thought-out hedging strategy.
There are two elements that can assist in selecting the appropriate time for currency transactions:
- Focusing on hedging the currency risk versus speculating in future market moves, and
- Minimizing losses when you are wrong and letting success build when you are right.
Experienced traders the world over will affirm this truth: you can be wrong 50% of the time and still be successful as long as the losses you take are smaller than the overall profits you reap.
In the example above, the U.S. company stood to save more than $27,100. The inclination of the company was to take the savings and purchase the euros immediately, even though the payment was not due for several months.
A technical analysis of the euro revealed it was unlikely to go much higher than the 1.38 level (in technical analysis terminology, 1.38 was a strong resistance level). As the euro was not expected to break through this resistance level, it was highly likely prices would remain flat or fall as the time for the payment approached. Our advice was to put a portion of the company’s $27,100 savings from the currency conversion at risk by waiting to purchase the euros. For protection, the client placed a conditional buy order slightly above the current market price level. If the euro did strengthen, the buy order would be executed, resulting in a currency purchase that would be somewhat more expensive than an immediate purchase, but would still result in a lower overall transaction cost than paying in U.S. dollars as originally planned.
In actuality, the euro behaved as expected and began to trend lower against the dollar, dropping from a level of 1.38 to 1.28. The decline in the euro resulted in an additional savings of €70,500. This decreased the company’s transaction cost by more than 7%, all while ensuring that the trade would never cost more in dollars than the original projected payment to the vendor.
In international payments, payers should craft a strategy for each hedging transaction that includes clear goals; tight stop-loss limits; and, whenever possible, puts at risk only the incremental value created. By applying a prudent, well-thought-out hedging strategy, the U.S. company managed to reduce its overall transaction cost in total by more than 9%. A good understanding of the full life-cycle of a foreign-currency transaction and a smart hedging strategy can result in a powerful combination that not only makes a company more competitive globally but improves its overall margins.
Randy Ingargiola is vice president and manager of derivative operations at BOK Financial, a $26 billion bank based in Tulsa, Oklahoma. He is in charge of operations, marketing, and long-term strategic planning for the financial risk-management group.