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Better to Trade
in Domestic or
Foreign Currency?
How to Weigh the Risks

Richard Breen September 9, 2016

For treasures working with international companies that may be expanding into new markets or facing growing competition abroad, there comes a time to examine their exchange rate situation and consider the prospects of dealing in the local money of their foreign trading partners. This can be a daunting task for the cash manager who is often happier in the comfort zone of their home currency, leaving no room for concerns about FX volatility or the complexity of hedging. However, it’s when both the risks and the opportunities become far too great to ignore that treasurers who become too complacent will be pushed to make a choice, and how they make that decision and manage the consequences is crucial to the success of their organization.

Any business that might have its sights set on the market potential of a new territory, especially with recent trade incentives presented by agreements such as CETA, the opportunity for growth will drive them in that direction, but among the considerations of geopolitical, economic and social issues that should be evaluated is the value of either pricing or paying in the currency of those countries where you choose to expand. For example, if you were recently exploring business prospects in China you may be weary that importing goods from the region could increase your costs by close to 8%. That’s because you’ll be forced to pay in USD and in order to buffer the transaction costs the supplier will add an additional charge. However, as the People’s Bank of China continues to relax its controls of the currency and allow for more international trade we’re seeing greater adoption of the yuan by the world’s major financial institutions. In Canada that will likely mean a local settlement dealer in the very near future and not only will settling in RMB make more sense but conducting business with this partner will become even more attractive.

Alternatively, you might be working with a multinational that has settled nicely into a foreign market only to find itself with new adversaries that are also coming from abroad but now making their goods available to their customers in domestic prices. Competition has then forced you into a corner and it’s time to up your game as buyers become tired of you offloading your currency risk onto them.

Whether you choose to deal in a local currency from a best practices perspective or from a place with little alternative, as a treasurer you must have a plan and that only comes with knowledge and when necessary, the help of an expert risk management strategist.

FX – Is it Worth it to Play?

There’s no one size fits all when it comes to judging foreign exchange risk and devising a method for containing it, but developing a currency policy tailored to your needs as you diversify into new markets and improve market share is one step in favor of better cash management and forecasting. When a treasurer sits down with their sales team to plan the course for the year and the SWOT assessment, looking at financial statements and sales targets, exchange rate expectations should be part of the discussion.

It comes down to overall business model, margin sizes and industry, in particular, how sensitive that industry is to rate fluctuation.

Astute market participants have observed that while volatility, as measured by the ‘fear index’ (VIX), is at record lows due to the summer doldrums, history has proven that these relatively low levels of volatility are unlikely to persist on a continual basis.  Although financial markets absorbed the British referendum in stride, and without much of a negative impact on asset prices, the tectonic plates of the international economic landscape are constantly shifting, and it would be unwise to assume that it will be smooth sailing for financial markets throughout the remainder of 2016.  Not only will the outcome of the Presidential Election in the United States exert influence on the US dollar, but should the Federal Reserve deem it appropriate to resume monetary policy normalization through additional rate hikes, the widening chasm of monetary policy divergence will ultimately inject greater amounts of volatility into foreign exchange markets.

Thankfully, while there are many variations of risk tolerance to these events, so too are there policies and tools to match.

Hedging your Decision

It all comes out even in the wash; at least that’s what many small to mid-size companies choose to believe who engage in a more passive FX strategy. Treasurers who take this approach when dealing in multiple currencies perceive that as one exchange rate accumulates losses for them, another might bounce in their favor and ultimately balance margins out. However, this doesn’t allow for measurable forecasting with too many variables left unknown. Rather, there are simple and sophisticated products that can both protect and even make good of market swings for potentially favorable returns.

Forward contracts are the most basic tool that allows you to lock in your forecasted rate for a fixed amount of time. They’re quite flexible in that they allow for a settlement date based on the payment schedule you prefer. Those dealing in currencies of less developed regions, for example, markets in Asia or South America, you may opt for a non-deliverable forward, a short-term agreement that requires no principal payment at the end of the contract. Diversifying your hedging portfolio by taking advantage of potentially favorable rate fluctuations, however, means employing an option strategy. When combined with a traditional spot or forward, a structured option allows a company to hedge their losses without having to forgo any gains in value. It’s a proven strategy but its usefulness will depend once again on margins sizes, risk tolerance, and overall business model.

If your company’s global footprint is expanding, forcing you to become literate in some new currencies, be open minded to the advantages of working in the local coin but keep your eye on the risks and plan accordingly.