The euro's 15% decline against the U.S. dollar in the past year highlights one of the major risks of doing business overseas -- currency risk. Companies large and small buying and selling products globally need to understand and manage foreign exchange risk. Lately some of the world's largest companies -- McDonald's Corp., Xerox and Coke bottler Coca-Cola Enterprises Inc. have acknowledged that currency fluctuations hurt their earnings in recent months.
As volatile as the foreign exchange markets appear this year, you don't have to look back very far to find even greater swings. In 2008, the euro fell 20% against the dollar in less than five months, and again from early December 2009 to June 2010 it fell 20%.
And the volatility is not confined to Europe. From early February to mid-March this year, the Japanese Yen plummeted a whopping 9% against the dollar.
The good news is companies can manage currency risks and protect their profitability even in the most volatile of times. Here are five tips to help businesses cope with the risks of doing business overseas:
- Quantify your risk: Identify and quantify the company's foreign exchange flows and their timing. Often there are "natural hedges" where companies are both recipient and payer in the same currency. International trade involves currency exchange between two countries. So not only are products being bought and sold, there are two parties in the currency transaction. If you are an importer, for example, you should always try to get invoiced in the foreign currency so that you have control over the currency trade.
- Set a budget rate: Regardless where companies do business, setting a budget rate is key in protecting profit margins. The frequency in setting a rate varies based on product, profit margins, and currency. For high margin items a semi-annual or annual reset may be fine; while a low margin business may reset the rate monthly. This rate is used in calculating forecast revenues, expenses, assets and liabilities to the company’s functional currency. Basically, companies use this rate to set and manage their international business in terms of their domestic currency, thus eliminating changing numbers resulting in market changes.
- Define your plan goals: Based on your risk tolerance you’ll develop a hedging plan with particular goals. The plan should incorporate a target exchange rate, which can be based on the exchange rate as of the start of the year, or it might be the average exchange rate in the prior year. More sophisticated companies may have a projection based on an economic forecast and other variables. Whatever the formula, it is essential that the currency hedging plan be anchored to a target. Your plan should consider various outcomes. Anticipate the best case and the worst case scenarios so you have determined in advance how you and your business will react under various circumstances.
- Execute your hedge program: You'll want to understand the tools for achieving your goals. Some of these include forward contracts that lock in an exchange rate at which a transaction in the future will occur, options that give the option holder the right but not the obligation to exchange currencies at a set rate, stop-loss orders that close a position if the currency declines to a set level. These are just a few of the tools available to mitigate currency risk. You'll want not only a customized program for your business but also a financial advisor with the experience and resources to execute the program.
- Monitor and adjust your hedge: You should review the strategy throughout the year and reassess market and economic conditions and your currency position. Market conditions change globally and within regions, so you need to stay on top of changes and be prepared to adjust your foreign exchange hedging strategy accordingly. If the currency has moved in your favor, for example, and you have margin, put a stop loss in place to lock in your currency profits.
Keep in mind that although (hedging can help you manage the risk of doing business in a foreign currency, there may be costs associated with these instruments. Aside from the cost, there are risks inherent in derivative contracts, such as geopolitical risk (for emerging markets), and counterparty risk (your customer’s ability to pay or deliver promised goods or services). Consult a knowledgeable financial advisor to make sure you understand both the advantages and the risks of any hedging strategy.
Doing business internationally is exciting, but it has added risks compared to businesses that operate domestically. If you recognize the risks of doing business in a foreign currency, you can learn to manage those risks and protect your company even in the most volatile times.
Andres Bergero is a Vice President and Senior Foreign Exchange Advisor in the Capital Markets Division at San Francisco-based Bank of the West.