Selling to overseas buyers is complicated business and can appear overwhelming when considerations such as cross border credit, political and regulatory risk become part of the equation. In a post 9/11 world we have more concerns and volatility than we did before. Despite these factors, companies cannot ignore the prospect of selling product to customers who happen to be located overseas and want to purchase or license your product. We have clients whose early or even initial sales volume is generated from overseas customers. Whether significant additional sales revenue of existing product or critical early sales volume of a new product, such opportunities should not be missed. Considering these issues, it is not surprising that companies seek to avoid the additional complication of sales denominated in foreign currencies such as the euro, yen or British pound to name a few.

Many presume that pricing in U.S. dollar terms eliminates the risks associated with the volatility and convertibility of the exchange rate between currencies. However, billing an overseas buyer in U.S. dollars merely passes the exposure to the buyer, and it does not change the fact that a transaction is booked in the currency of one party, but is a foreign currency to the other. Put another way, every international transaction has foreign exchange risk. When the burden of hedging foreign exchange risk is put to the buyer, the exporter loses control of the final price. If the importer does not manage this exposure and if the dollar appreciates significantly, the final cost of purchase will increase and result in an unattractive final cost of purchase.

In a competitive world, a U.S. company could very well bid against local competition using the buyer's own currency or a competitor from any other country that is willing to price in the importer's currency. Companies can also encounter situations where the only choice is to price in the buyer's currency or not lose the sale.

The good news is that the transactional risk of denominating a sale or multiple sales in a foreign currency can be managed. There are a variety of techniques that can be used to hedge some or all of the exposure and there are strategies to protect companies from the downside of a negative change in cross currency rates that still enable the company to benefit from an exchange rate that moves in its favor. Let's take a hypothetical transaction and introduce you to some of the hedging tools that can be used to manage this risk.

Our hypothetical company, Super Software Inc. is about to enter into a contract to sell a software license valued at $500,000 to Enterprise, GMBH in Germany. The buyer wants to pay in 180 days and it wants to be billed in euros. The current, or "spot," rate is $1.1670 equals 1.0000 euro. But what will that spot rate be in six months? When Super Software enters into the contract with Enterprise, GMBH it will be in a net long position of EUR 428,449 (based on today's spot rate), which will last until the euros are received in six months and converted to a U.S. base currency or until it is offset by means of a hedge. Until then, Super Software Inc. is vulnerable to changing values between the euro and the U.S. dollar. For the first six months of 2003, the euro appreciated over 10% against the U.S. dollar. From mid-year 2002 to mid-year 2003 the euro rose over 20%. Super Software does not want to be exposed to that type of volatility and would like to lock in its U.S. dollar profit margin. Below are the most common types of hedging tools that Super Software could use:

Natural Offset

When a long or short position is created by a transaction, such as the Super Software euro currency sale to Germany, a natural offset will occur if there are business outflows in euros to counter the long position created by the sale. For example, if Super Software had an upcoming obligation to pay EUR 430,000 to an equipment supplier or an outside vendor, which would reduce or eliminate the foreign exchange risk created by the sale, there would be a natural offset. In this example, the company would not have to do anything, and it has hedged its position in the normal course of business. Frequently, software companies will have recurring payments overseas to fund subsidiaries or software development teams. Thus, billing in these local currencies would offset the foreign exchange exposure that exists in these current and future payment streams. The monthly transfer of a fixed amount of yen to fund a Japanese subsidiary that starts out in February at $100,000 per month can be a significantly different amount in March -- let alone by the end of the year. As international business becomes more extensive, companies can utilize such natural offset strategies as leading and lagging receipts or payments to manage their foreign exchange exposure. Here, the company should have a good forecast of upcoming currency cash flow.

Forward Foreign Exchange Contract

This is probably the most common instrument used to offset the risk of exposure in international trade transactions. Here two parties agree to exchange a fixed amount of foreign currency into another on a fixed date in the future and at a fixed price or rate. There will be no exchange of currencies until the maturity of the contract. In our example, Super Software could sell EUR 430,000 to its bank at a forward rate of EUR 1.1600 with settlement in 180 days. At this rate Super Software would receive $498,800 from its bank into its account at maturity and instruct Enterprise GMBH pay its EUR 430,000 obligation into an account specified by Super Software's bank, per the terms of the forward foreign exchange contract.

Wait a minute! What happened to the $500,000? Did it really cost $1,200.00 to lock in the rate that was provided by the bank? Banks usually do not charge a fee to lock in a forward rate. The forward outright rate (1.1600) is made up of two parts: the spot rate (1.1670.) and the forward premium or discount (-0.0070). In this case, the discount of 0.0070 is driven by the interest rate differential between the higher yielding EUR and the lower yielding US$ expressed in exchange rate points. In general, sellers of EUR would earn extra interest income if the seller holds on to the higher yielding EUR and delivers on a later date. To compensate for the extra interest earned by holding on to EUR instead of US$, the seller has to sell at a forward discount to reflect the interest rate differential earned during the same period. If this discount does not equal the interest rate differential between the two currencies, there will be arbitrage opportunity, which, in a market as perfect as the foreign exchange market, can only exist for a flashing moment.

Thus, it is not the perceived future strength or weakness of the currency that causes a currency to trade at forward premium or discount. It is all driven by the interest rate differential between the two currencies. A higher yield currency (EUR) will be sold or bought at a discount versus a lower yield currency (US$). In our example, one might argue that Super Software does not hold any EUR to earn that interest differential to compensate the $1,200 forward discount. But in practice, Super Software would have factored into its pricing or would negotiate extended payment terms taking into consideration of any unfavorable discount or premium.

Forward Window Contract

A forward window contract is a forward foreign exchange contract that has a more flexible settlement date. While the basic forward contract has a specified date of maturity or settlement, the Window contract is set to provide flexibility regarding the specific date within a range. In our example, Super Software is due to receive its EUR 430,000.00 on January 15th from its German customer. However, it wants to have the flexibility of settling the foreign exchange contract in a range from January 12th through January 16th. This flexibility is accommodated in the rate provided by the Forward Window Contract.

Foreign Currency Option

An active market exists for the purchase and sale of foreign currency options. Thus, Super Software could hedge its downside risk by purchasing a euro foreign currency option. The buyer of an option pays an up front premium to have the right -- but not obligation -- to transact a spot foreign exchange at the set rate at some future date, per the terms of the contract. Use of an option allows Super Software to hedge some or all of its downside risk, but also enables the company to benefit if the euro becomes stronger against the dollar. In this case, Super Software allows the option to expire without exercising it and receives the higher dollar amount when it converts the incoming euros to dollars when the German buyer makes payment under terms of the sale. So, if the spot rate at the outset of the export was $1.1670 = EUR 1.0000 and the company purchased a euro Put option to have a right to sell the euros at a future date for the same spot exchange rate, it hedged its downside. If the euro strengthens to $1.1800 = EUR 1.0000, Super Software could let the option expire and receive $507,400 when it converts the incoming euros at the higher prevailing exchange rate instead of the original $500,000, if it exercised the option. Unlike a forward foreign exchange contract there is a specific cost or premium paid by the buyer of the option. This cost is frequently a deterrent to companies seeking to hedge foreign exchange exposure. We should note that currency option users frequently use multiple options in the context of a well-developed foreign exchange management strategy.

Foreign Currency Loans

Since the long position in euros created by the sale to Germany is an asset (Account Receivable) until it is paid, the company could offset that asset and related exposure by creating a counter liability. Super Software could borrow about EUR 430,000 and invest the proceeds in an interest bearing account. When the German customer makes payment, Super Software could repay the loan without entering into any foreign currency transaction. Issues to consider are the arrangement and terms of the loan facility and the legal and credit costs. This type of exposure management is most suitable for companies with extensive foreign activities or investment.

Other

Befitting the vast scope of the global foreign exchange and other financial markets it is not surprising that a wide array of other hedging strategies and instruments can be used to manage foreign exchange exposure. Examples of such instruments include "synthetic forwards" using spot rates, zero cost options, participating forwards and collars, to name a few. These vehicles tend to be more complicated and utilized by larger companies with active treasury management personnel and are worthy of more extensive discussion.

Revenue generation is the life-blood of the business enterprise. Sales to companies outside our borders contribute to, and in many cases can be the driver of, a company's success. When dealing with foreign customers there are added issues and considerations. Fortunately, the question of foreign exchange exposure can be managed in a number of ways to stimulate sales, protect margins and manage risk.

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