QUESTION
Assume that you have been engaged to provide foreign exchange risk management advice to a local firm which exports extensively to Japan, and has just signed a major export contract under which it is due to receive $US 10 million in six months time. Outline the advice you would give this firm on the best ways of managing its US Dollar risk exposure.
SOLUTION
In the question is given that the local firm is based in USA and is exporting to Japan. The contract is of six months and the value of the entire contract in US dollars is $10 million at the time of finalizing the contract to be received spanning a time duration of six months .
Foreign exchange dealings are associated with a lot of risk; they are volatile and show fluctuation even during short time intervals, if the value of the foreign currency, in this case yen, falls against the dollar, then the exporting firm stands to loose (if the price has been pre specified to buyer(s) in yen) , but on the other hand if the value of yen rises against the dollar the exporting firm gains. Here the exporting firm should try to manage its foreign exchange dealings in such a way so as not to attain less than $US 10 million, if not more.
The nature of risk associated with dollar against the yen can be gauged by the graphs given below:
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The above graph is for a 30 day period, and even within this short period we can observe the range of fluctuation.
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The above graph is for a 120 day period. The value of $1 was 82.286 yen as on March 29, 2012.
(www.x-rates.com, 2012)
The local firm can manage its foreign exchange risk in the following ways
- Study foreign exchange movement patterns, and if trend is favorable, then get payment in local currency without any adjustments.
- It can ask the buyer(s) to settle the entire payment in advance in dollars.
- It can ask the buyer(s) to settle the entire payment in advance in local currency at a pre determined exchange rate.
- It can ask the buyer to pay periodically at prevailing market rates of exchange, the losses if any during the realization period due to exchange rate fluctuation to be adjusted in the next payment period.
The method of managing foreign exchange risk would depend on the nature of business, number of buyers and buyer seller relationships. If the seller is a risk taker and foresees favorable trends in exchange rate movements, then he may ask the buyer(s) to pay in local currency. In this case the seller will benefit if the amount of payment has been specified to buyer(s) before hand in terms of yen, at the time of finalizing the contract.
Getting advance payment in dollars may not be possible in all situations and may be a difficult proposition for the buyer(s) (http://trade.gov,2012).
If the buyer(s) is/are ready to pay the entire money in advance in local currency, then the exchange rate would need to be predetermined. The prevailing market rate of exchange would need to be adjusted with historically worked out data pertaining to possible downward fluctuation in foreign exchange rates from the date from which payment becomes due till the date payment is realized. This would be a cumbersome process and will be based on possibilities based on past foreign exchange rate movements which might not apply in future, and besides a huge amount of historical data would be required to work out the exchange rate, and if in this period the value of local currency rises against the dollar instead of the assumed fall, then the exporting firm would loose.
Lastly the firm may ask the buyer(s) to pay money due periodically at prevailing market rates of exchange. The firm can attain data for the period from which payment became due till which payment was realized and if any losses have occurred during the realization period, then such losses can be adjusted in the next payment period. In this case the buyer(s) may ask to adjust in cases of gain as well and chances of gaining from foreign exchange rate fluctuations would become nil.
Hence prior to settling the issue of appropriate payment terms with buyer(s), the seller would need to take into account its nature of business, number of buyers, relationship with buyers and also the cost of managing foreign exchange rate fluctuations. The cost should not be significant in comparison to the entire amount of deal and benefit of adopting the method. Also the seller should keep himself/herself informed about market conditions and factors that influence foreign exchange rates.
Reference
USD-American Dollar Exchange Rates, viewed on 30th march 2012, http://www.x-rates.com/d/USD/table.html
Foreign Exchange Risk Management, viewed on 30th march 2012, http://trade.gov/publications/pdfs/tfg2008ch12.pdf
JD91
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