The global pandemic has highlighted many issues hitherto unnoticed or of little priority to corporations across a variety of areas. This is also true for those dealing with recurring or nuisance payments, particularly international payments.
Relying on outdated payment methods such as paper checks, accepting high fees or unfair rates, or simply finding yourself at the mercy of volatile currency markets can leave your business vulnerable when dollars and cents become integral to survival in a depressed economy. What’s more, many businesses misunderstand concepts around international payments, or do not understand just how much risk they are exposing themselves to.
Uncertainty is the number one nemesis to business success. Hedging is often misunderstood to mean making risky speculations on where currency rates will move in the future. Those who have adopted this mentality around foreign currencies found themselves in a dangerous position when COVID-19 began wreaking havoc on markets, as it continues to do. It was impossible to make educated predictions on the movements of currencies based on trends or data releases, because all semblance of normality or predictability in the world had been eclipsed by the virus.
If you implement a smart hedging program, you can turn this uncertainty to a known-unknown. In accounting terms, hedging will turn the exchange rate from a variable cost to a fixed cost. Thus, hedging minimizes the impact of foreign exchange rate fluctuations on future cash flows.
How to Create a Foreign Payments Risk Reduction Strategy
Step 1: Identify your Exposures
Before one can create a strategy to avoid risk in cross-border payments, you must first analyze and identify them. To do this, identify the foreign exchange exposures that are the result of a mismatch in cash flows. These typically occur because of timing differences between a firm sale (invoice) and actual cash flows (collection/payment). These will highlight the times of the month or year when you are left vulnerable to market volatility and shifting exchange rates.
A simple example of this type of mismatch in cash flows would be when a company enters into a purchase order for inventory from an overseas vendor. It will take 3 months for the vendor to deliver the inventory, so the domestic company will have a 3-month exposure to the vagaries of the currency fluctuation.
A more complex example of currency exposure would be a service contract that lasts several years with scheduled payment intervals. A company faced with this exposure would want to hedge the scheduled payment dates to eliminate its currency risk.
Step 2: Calculate exposure for a specific time frame
Now, simply drill down deeper into this data.
For instance, ABC Company, located in the USA, has agreed to buy a large order of industrial gauges from XYZ Company in Germany for €800,000 euro in 3 months from now.
The current EUR/USD exchange rate at the time of the deal is 1.13. ABC Company therefore expects to pay EUR $904,000 for the gauges.
In 3 month’s time, the EUR/USD rate spikes to 1.20 due to an unforeseen event. (We have seen this occur recently with events such as BREXIT and coronavirus.)
Now, let’s go deeper still and look at the result of doing nothing and taking out an insurance policy of hedging the currency fluctuation risk.
Scenario 1: If ABC Company does nothing to mitigate its risk
In 3 month’s time, when the invoice from Germany is due, the exchange rate has moved adversely against ABC Company. The gauges would now cost $960,000 (800,000 * 1.20).
ABC Company would pay $56,000 or 6.2% more than originally anticipated.
They can avoid this shortfall by taking the next step in this strategy…
Step 3: Hedge accordingly.
Use the exposure you’ve calculated in Step 2. This is where hedging instruments such as forwards and options can be used to turn the uncertainty of the foreign payment exposure into a known unknown. The uncertain cost caused by currency fluctuations are turned into a known, fixed cost, allowing you to concentrate on all the other aspects of running your business.
Scenario 2: ABC Company does use a Forward contract
ABC Company decided to use a forward contract at the time of the sales to lock in their price. They purchased a forward contract at a rate of 1.1350.
After 3 months, ABC Company pays for the gauges from Germany. Even though the exchange rate moved adversely to 1.20, ABC Company is protected by the forward contract and the gauges would now cost $908,000 (800,000 * 1.1350).
The result is that ABC Company saves $52,000 by thinking ahead and protecting itself with a forward which locked in its future cost.
If this type of calculation seems daunting, it may be wise to engage with an international payments company who can offer consultations and solutions that can help mitigate your risk even further. During times of uncertainty, such as the current pandemic, it is vital for businesses to protect themselves and mitigate risk in cross-border payments to ensure your business isn’t vulnerable to volatile markets.