Exchange rate risk: basic mitigation strategies

If you do business with customers in other countries, how do you protect yourself from currency risk? A number of my clients are dealing with this issue right now, so I thought it’d be timely to summarize some basic currency risk mitigation tactics.

The problem: if you agree to get paid in a currency other than US dollars (USD), then if that other currency depreciates between the time you sign the deal and the time your customer pays you, your customer’s payment will translate into fewer USD, so you’ve lost money.

In the example below if you agree to get paid 10,000 Euros, worth 1.34 USD at contract time but depreciates by 10% to 1.21 USD when your customer pays you, you’ll make $1,339 less.

Currency risk example: Euro rises or falls by 10% versus U.S. dollar

Currency risk example: Euro rises or falls by 10% versus U.S. dollar

Of course it can work the other way, too: if the other currency appreciates, you make more money. But most small businesses don’t try to make money on the potential upside from currency fluctuations. They just want to protect against the downside.

A few mitigation strategies (by no means a comprehensive list):

  1. Denominate the deal (agree to get paid) in USD, not the other party’s currency. This eliminates the risk for you.
  2. If denominating in another currency, share the risk of currency fluctuation with the client. They can pay in their currency as long as their currency doesn’t fall by more than X% by the time they pay you. Below that X%, they make up the difference in USD value. This sets a floor as to how much you can lose due to currency fluctuations. Similarly, they might ask you to assume such risk in case their currency rises against the dollar.
  3. If denominating in another currency, pad your pricing to include some extra margin to protect against currency risk.
  4. If denominating in another currency, pay your vendors, if possible, in that same currency. You’ll still lose money if that currency falls against the USD, but you’ll lose money only on your gross profit, not on total revenue.
  5. If denominating in another currency, and the deal size and length warrants it, consider buying insurance (a hedge) against currency risk.
  6. Ask your bank how they might be able to help. Larger banks have some tools they can deploy on your behalf. Smaller banks often have to work through larger ones.
  7. Check with your bank to see what they charge for converting the currency received and what the wire fees are if you pay in other than dollars. The fees can be significant.

A few other notes:

It’s the reverse for vendors: if you’re paying in your vendor’s currency and it devalues against the dollar, you make more money because you satisfy your obligation to them with fewer dollars. If their currency appreciates against the dollar, you make less money because it takes more dollars to satisfy your obligation to them.

Remember too to make sure that you get paid at all. If it’s a new customer or one with insufficient credit history/rating, there are devices banks can deploy to help protect you in case your client doesn’t pay: letters of credit, non-payment insurance, etc. A letter of credit can work like an escrow account to be sure, in the case of inventory for example, that the goods actually change hands.

Article:

http://www.cfo.com/article.cfm/14485382/1/c_14485781 CFO Magazine 4/1/10.

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