United StatesChange Country

Forward Contracts, Foreign Bank Accounts, and the Advantages of Transacting in Local Currencies

By Karen Lynch

Export.gov notes that most U.S. small or midsize enterprises (SMEs) conduct import-export business only in dollars to avoid foreign exchange risk and other complications, even though “foreign buyers today are increasingly demanding to pay in their local currencies.”1 Besides missing out on potential business opportunity, the choice of currency can impact an SME’s supplier relations, contract terms, and pricing strategies. For greater flexibility, companies can leverage the advantages of forward contracts, foreign bank accounts, and other risk mitigation strategies to transact in other currencies with less risk.

Weighing Dollars vs. Foreign Currencies

 

Each side of a transaction faces its own foreign exchange risks, as the relative value of currencies shifts in the time between a purchase agreement and final payment. But there are associated operational and market risks, as well.

 

Many foreign customers and suppliers would rather use their local currency—so much so that suppliers may charge a premium on dollar-denominated orders to cover their risks and currency conversion costs. So, U.S. importers’ benefits from using local currencies can include lower purchase prices. Other business concessions, such as extended payment terms, also become more feasible for suppliers that are paid in local currencies.2

 

Dollar-based exporting can carry disadvantages such as pricing fluctuations in overseas markets, inconvenienced customers, and delayed payments. The risks are that products could become less competitive, customers might turn to more accommodating vendors, and the wait to get paid is increased by currency exchange processing.

 

Nonpayment is another possible outcome, if a foreign buyer can no longer pay an agreed price due to a significant devaluation of the local currency. Or, your cash flow risk could increase if customers time payments to take advantage of exchange rate fluctuations.

 

Exporting in dollars has potential upside, of course. “If the foreign currency increased in value … you would get a windfall in extra profits,” according to Export.gov. “Nonetheless, most exporters are not interested in speculating on foreign exchange fluctuations and prefer to avoid risks.”3

 

Both when importing and exporting, the choice of currency can ultimately help build relationships. To keep their supply chain steady and reliable, importers may help to alleviate their suppliers’ cash flow and margin exposures to foreign exchange risk. For exporters, “brand loyalty—and the repeat purchases associated with it—can be earned by saving foreign trade partners the hassle and risks associated with currency conversion,” according to one bank.4

 

The choice of currency may be determined by many other factors, as well. Entire industry sectors, such as energy, favor dollars. In other situations, suppliers might need dollars, instead of local currencies, to purchase their inputs. But there are operational and market risks to automatically assuming that all foreign suppliers want to do business in U.S. dollars, simply because of the dollar’s traditional dominance in international trade.

 

The Advantages of Forward Contracts and Foreign Bank Accounts

 

To hedge against foreign exchange risk, many companies use forward contracts. These are agreements with a financial institution to exchange the sale price, in the importer’s currency, for the equivalent in the exporter’s currency, at a particular date in the future. Without this bridge between the time of sale and payment, for instance, a 20 percent drop in the importer’s currency could mean paying 20 percent more for the goods purchased.5

 

Among the advantages of forward contracts, one banker noted that fixing an exchange rate through hedging can be less expensive for an importer than paying the premium a supplier might otherwise add to a dollar contract.6 Export.gov advises that forward delivery dates be chosen carefully, for example, using a “window forward” that allows for delivery between two dates, for the best exchange outcomes.7 Other options for minimizing risk include using online platforms that provide additional advantages to forward contracts, with alerts that enable such strategies as limit orders (making a transaction when rising exchange rates reach a pre-set limit) and stop loss orders (when falling exchange rates reach a pre-set limit).

 

If doing business regularly in a particular country, U.S. companies might choose to open a foreign bank account. That way, when the exchange rate is favorable, dollars can be deposited, locked into the other country’s currency, and ready to spend. Another advantage of foreign accounts over forward contracts is that local customers and suppliers can more easily conduct business, as well. The drawbacks may include such matters as the application processing and tax accounting for a local account, which vary in terms of difficulty from one country to the next, or from a global bank branch to a domestic bank.

 

Such accounts can also aid in avoiding foreign exchange exposure by simply netting foreign currency receipts with foreign currency expenditures. In an example provided by Export.gov, “the U.S. exporter who receives payment in pesos from a buyer in Mexico may have other uses for pesos, such as paying agents’ commissions or purchasing supplies in pesos from a different Mexican trading partner.” If the company’s export and import transactions with Mexico are comparable in value, pesos would not be con¬verted into dollars, and foreign exchange risk would be minimized.8

 

Three Types of Foreign Exchange Risk

 

Consultancy McKinsey & Company identifies three kinds of foreign exchange risks:

 

  • Transaction risk,
  • Portfolio risk, and
  • Structural risk.

“As the most visible currency risks a company faces, transaction risks are also the simplest to measure and manage,” according to McKinsey, primarily through the strategies outlined above.9 However, other foreign exchange risks are not as manageable through those approaches.

 

“Structural risks,” in which a company’s cash inflows and outflows react differently to currency changes, are the hardest to manage, McKinsey said. “The only effective way to reduce structural exposure is to reduce the underlying mismatch of cash flows—for example, automobile manufacturers from Germany and Japan having shifted production to the United States, thereby lowering their structural exposure to the dollar.”

 

Companies are also exposed to “portfolio risk,” as their cash flows from foreign operations are translated into dollars for financial statements, performance management, or investor communications, noted McKinsey. “Because portfolio risk is unlikely to cause financial distress, this is in general not a risk that companies need to actively manage.”

 

The

Takeaway:

As companies weigh the pros and cons of doing business in foreign currencies, the need may arise to manage related foreign exchange risk. “One of the biggest risk factors involved in operating an import or export business is that while your purchase or sale is in progress, the value of currency may change relative to the value of the U.S. dollar,” according to Trade Finance Global, a financial advisory.10 Risk mitigation tools and strategies such as forward contracts and foreign bank accounts provide advantages that can mitigate the risk.

Karen Lynch - The Author

The Author

Karen Lynch

Karen Lynch is a journalist who has covered global business, technology and policy in New York, Paris and Washington, DC, for more than 30 years. Karen also is a principal at Content Marketing Partners.

Sources

1. “Trade Finance Guide Chapter 14: Foreign Exchange Risk,” Export.gov; https://www.export.gov/article2?id=Trade-Finance-Guide-Chapter-14-Foreign-Exchange-FX-Risk-Management
2. “Paying in Local Currencies: A Smart Decision for Both Importers and Exporters,” UMB; https://www.umb.com/wps/wcm/connect/umb/e517f9a4-fd98-48e0-a477-21bb0b4e8481/UMB--Paying-In-Local-Currencies.pdf?MOD=AJPERES&Paying%20in%20local%20currencies
3. “Foreign Exchange Risk,” Export.gov; https://www.export.gov/article?id=Foreign-Exchange-Risk
4. “Paying in Local Currencies: A Smart Decision for Both Importers and Exporters,” UMB; https://www.umb.com/wps/wcm/connect/umb/e517f9a4-fd98-48e0-a477-21bb0b4e8481/UMB--Paying-In-Local-Currencies.pdf?MOD=AJPERES&Paying%20in%20local%20currencies
5. “What is a Forward Contract Against an Export?” Investopedia; https://www.investopedia.com/ask/answers/061615/what-forward-contract-against-export.asp
6. “4 Benefits to Paying Foreign Suppliers in Their Own Currency,” USBank; https://financialiq.usbank.com/index/improve-your-operations/manage-payments/Pay-foreign-suppliers-in-their-currency.html
7. “Trade Finance Guide Chapter 14: Foreign Exchange Risk,” Export.gov; https://www.export.gov/article2?id=Trade-Finance-Guide-Chapter-14-Foreign-Exchange-FX-Risk-Management
8. “Trade Finance Guide Chapter 14: Foreign Exchange Risk,” Export.gov; https://www.export.gov/article2?id=Trade-Finance-Guide-Chapter-14-Foreign-Exchange-FX-Risk-Management
9. “Getting a Better Handle on Currency Risk,” McKinsey; https://www.mckinsey.com/business-functions/strategy-and-corporate-finance/our-insights/getting-a-better-handle-on-currency-risk
10. “How Can Currency Hedging Help Importers and Exporters?,” Trade Finance Global; https://www.tradefinanceglobal.com/posts/conceptualizing-forex-volatility-can-we-predict-the-unpredictable/

Related Articles

Combining Forex Options and Other Financial Instruments for a Tailored FX Risk Management Strategy
Forex Knowhow: What Are Futures and Options?
Forward Contracts and Forex Volatility