Foreign Currency Considerations

This first section describes the principles on which Datafile Software based its foreign currency implementation; the terminology used in this manual; and the considerations to think through when installing a foreign currency system.

 If you are new to the concepts of foreign currency and can see that your business is going to become more involved with it, you are well advised to seek professional advice in handling it. The following notes are offered to familiarise you with some of the terms and concepts which occur when dealing in foreign currencies.

Background to Foreign Currency Management

 Companies who do not deal with companies in other countries have no need to worry about different currencies. All their transactions, bankings and reports take place in their local currency. However, once they start to trade with organisations in other countries, sooner or later they will have to deal with other currencies.

 If such transactions are few and far between, companies often delegate the problem to their bank. If they have to pay a foreign bill, they arrange for their bank to send the money, recording in their own books just the local currency equivalent of the payment. If a customer wants to pay some invoices in its own currency, then again they will use their bank to exchange it into local currency when the money is received and record just the equivalent local currency amount.

 Although the bank charges for providing these services, sometimes it looks as though they’ve charged extra, whereas at other times it’s almost as though they’ve forgotten to charge at all. These variations in fact are due to the fluctuations in the exchange rates between currencies. And that is the essence of the foreign currency problem.

 An Example

 Let’s suppose a UK company negotiated with a new customer in France and obtained an order for goods at £40,000. Bargaining was hard, and the net margin on the deal under standard costing was only 4.5%. They’d established their own costs at £38,200, but it was hoped that this was only the first of a continuing series of orders, so they were prepared to accept just a small margin this time around.

 One of the terms of the deal was that the French company was to be invoiced, and would pay, in euros. Another was that 30 days credit was offered. As a result, our UK company kept their eye on the euro, standing around 1.3900 to the pound at the time, and agreed a price of €55,600.

 The shipment is now ready, and our UK company needs to raise an invoice. An invoice for €55,600 is duly raised and sent once the goods are despatched. The post is studied anxiously in a month’s time, and — a few days late — a cheque is received from their French customer to the value of €55,600. With relief, this is taken down to the bank, where the cashier confirms that the bank can buy euros at an exchange rate today of 1.4574 euros to the pound after all charges (currencies are usually quoted to four places of decimal). Back in the office they realise to their horror that although the French company’s account is now clear in terms of euros, they have received only £38,152 — under the cost of the deal, leaving no profit at all.

 Exchange Differences

 They have just learnt about the differences in value which occur due to the difference in time between the two sides of a transaction. Of course, things might have gone the other way. If the bank had been able to offer them 1.3535 euros to the pound that day, the cheque would have translated into £41,078, giving them an increase in profit on the deal (from £1,800 to £2,878).

 So one of the new factors introduced when you start to deal in foreign currencies is the gains and losses you may make when converting to your local currency. These are known as exchange differences.

 Another factor is that the exchange differences only truly appear in real money terms when you actually convert between one currency and another. In the example above, had our unfortunate company also held a Euro bank account then that would now hold €55,600. If they did a lot of trading in France, then they could use that to pay French invoices which — in UK pound terms — might now be cheaper than before, thus clawing back some margin.

 The trick is, of course, to manage things so that either exchange differences broadly balance out during the year, or even that you make you a profit out of it.

Foreign Bank Accounts

 If you start to do any volume of trade with many customers and/or suppliers in different countries, then you soon realise that the rate you are offered to exchange a currency is different according to whether you are buying (to pay a supplier) or selling (because you’ve just been paid by a customer). This "turn” is the consideration by which the foreign exchange dealers make their money.

It may pay you to open up bank accounts in the currencies in which you deal. Your own local bank can help to set up foreign currency accounts with them — you do not need to find a foreign bank in each country. Now you can bank foreign receipts in the account for that currency, and pay suppliers from it too, without suffering any losses on the turn between buying and selling the currencies.

 There’s still a risk, however. If you leave money in a foreign currency account and that currency devalues, you’re suddenly faced with a loss (just as you would if you’d negotiated an overdraft to pay suppliers, and that currency revalued upwards). Of course, if the rate of exchange had gone the other way, you would have profited.

 Hedging your Bets

 If you make only a few deals in other currencies, whether you are buying or selling, then the risk to you from currency fluctuations is small. You might include an extra clause in the terms of the deal to cater for other than minor fluctuations. However, if you start to make a considerable business of selling overseas, or of buying from abroad, then it may not be possible to include such terms as standard. It is prudent to seek ways to protect your company from currency fluctuations.

 Overall exposure to exchange rate fluctuations is, of course, enormous given the huge volume of world trade. As a result, markets to swap currencies have arisen — the foreign exchange markets. The players in these markets are largely the banks and foreign exchange brokers. Some international organisations may have a broking arm just so that they can be in on the act. Speculators can play the exchange markets; at times having the power to cause overvalued currencies to devalue, or the most respected financial institution to fall.

 Foreign exchange markets have developed sophisticated schemes whereby they can hedge against the risk of future losses and open up opportunities to gain from currency movements — these can be an absorbing topic of study. Most businesses, however, just want simple schemes to protect them against losses caused by currency fluctuations. They will use a broker or a bank to provide two main types of futures contracts, known as Forward and Options contracts.

Futures Contracts

 A futures contract is an agreement to exchange a specific amount of one currency for another at a specific date in the future (known as the expirationor maturity date) at an agreed rate of exchange (known as the exercise price). The rate of exchange offered by the bank or broker represents his best guess of where the rate will be on that date, adjusted so as to give him a profit on the deal. The benefit to you is that you will get that exact rate of exchange, regardless of what the actual rates are in the exchange markets when the date arrives.

For example, if the French company above had agreed to pay on a specific day and if a futures contract could have been taken at a rate of (say) €1.3875 to the pound, then our example company would have received £39,783 at the time of payment — not much less than they wanted, and still profitable. They can look on the £217 difference as insurance against exchange rate fluctuations. They also know to negotiate next time on the basis of forward exchange rates, not today’s!

 A common variant of the futures contract is becoming popular, often known as an open forward contract. Rather than maturing on a specific date, the contract can be fulfilled any time during a window of a certain number of days, such as (say) a named fortnight two months in the future. The advantage of this is, of course, that it allows you a certain amount of leeway to cater for late customer payments, or other cash flow difficulties.

Options Contracts

 An options contract is a variation whereby the exchange of currency can take place at any time between now and a future date, but need not be taken up at all if the real exchange rate turns out to be better. Options contracts carry a premium — that is to say, you pay money at the time you buy the contract, regardless of whether you eventually use it — so these are less commonly used in commercial environments.

 In the example above, if the French company had not been so exact about when it would pay, and had agreed to pay penalties if it did not settle by the agreed date, then an options contract might have suited. It would be exercised as soon as payment was received, but would lapse without worry if the French company were late paying. Here, of course, our company would need to be confident that the penalty would compensate for any negative exchange rate fluctuation if the French company were late paying and the option contract had expired without fulfilment.

 Some company financial controllers will spend considerable time and effort on cash flow planning to make sure they have the least "exposure” to currency fluctuations. Futures and options contracts will be negotiated to hedge against anticipated holdings of different currencies, and if they are cash rich they move currencies to maximise the interest earned on the balances, commensurate with the risk in each currency.

 Call or Put — Buy or Sell

Call and Put are jargon terms which you may meet, and are used by brokers in their foreign exchange dealings. Call means to buy; put means to sell.