When a seller quotes an export price for a product or receives an offer in terms of foreign currency, there is concern with the exchange rate fluctuations that may occur before the seller receives payment. When quoting prices in terms of the foreign currency, the exporter knows how many dollars are to be received at the current rate of exchange. However, when the customers pays in Sterling Pounds, Deutschmarks, Indian Rupees, Japanese Yen or some other acceptable foreign currency, the amount received in terms of dollars will depend upon the rate of exchange when the currency is converted. When the price is quoted in the foreign currency, the exporter accepts the risk of exchange fluctuation. Unless steps are taken to protect expected profits, a decline in exchange rates may reduce profits or even convert them into a loss.
Exporter’s Means of Protection
An American exporter can obtain protection against exchange losses by quoting a price in terms of US Dollars, thereby shifting the exchange risk to the foreign importer. In that case, unless the importer seeks protection, an unfavorable change in the exchange rate may cause the importer to pay a higher price (on the basis of his/her currency) then had been anticipated.
When quoting prices in a foreign currency, an exporter may deliberately accept an exchange risk if it is believed that the rate will be more favorable later, then the exporter is speculating on the merchandise export transaction, for the amount of profit will not be known until the payment has been converted to domestic currency. The exporter may be more inclined to accept this if exchange rates have recently been quite stable and if a product carries a wide price margin. Although the exchange risk may be taken into account in quoting export prices, such action could raise the price and thereby limit sales.
- Agreed-upon Exchange Rate: When exchange rates fluctuate within a comparatively narrow range, the exporter may be able to induce the foreign importer to agree upon a fixed or guaranteed rate of exchange, but arrangements such as these may be unobtainable at the very time the exporter is most anxious to protect profits. When the exchange risk is greatest because of wide fluctuations, the exporter who quotes foreign currency prices may find that the only safeguard is in the open exchange market, where foreign currency bills for future delivery are bought and sold.
- Hedging: When an exporter makes a sale, foreign currency may be sold for future delivery. Later, when a draft from the foreign customer is received, the exporter will present it to a banker and receive payment on the basis of the agreed- upon rate. A businessperson may hedge or protect export profits in a large measure by selling future contracts, if there is a future market for the foreign currency. When a sale is made, the exporter who expects to receive foreign currency at some future date may sell an equivalent amount of foreign currency for delivery in future at the time the foreign currency is expected to be received by the exporter. If the exchange rate declines, the exporter will receive fewer rupees for the merchandise transaction than anticipated, hit will be able to cover or buy back at a reduced rate the foreign currency that had been sold for future delivery. The profit derived from this future exchange transaction will approximately balance the reduced number of rupees the exporter is’ paid for the merchandise. In effect a fixed rate of exchange will again have surfaced for the exporter.
The sale of future contracts often affords real protection to the exporter, but it does not always eliminate the exchange risk entirely because the exporter may be unable to close the export sales contract and sell the futures contract at exactly the same moment. In the meantime the exporter bears the exchange risk. The futures and spot markets may not fluctuate in the same amount, so the transactions exactly offset each other. Bankers also have at times withdrawn from future exchange operations in some currencies, so hedging may not be possible in currency. Hedging through the use of future contracts implies that there is such a market. If the sale to a small country, or one with few international dealings, there may be no future market for the currency.
Importer’s Means of Protection
Importers, when buying merchandise in terms of foreign currencies, are faced with a possible loss of profit resulting from unfavorable exchange fluctuations. The importer, knowing that a given amount of foreign currency will have to be delivered at a future date, may purchase spot exchange when ordering imported merchandise. This will eliminate the danger of a rise in the exchange rate in the importing country, but in doing so the importer ties up funds until the merchandise is received. When purchasing imports in terms of a foreign currency for which there is a market for future exchange rate, the importer may hedge transactions by purchasing a future exchange contract. Thus, the importer is assured that when the time comes for payment, the necessary foreign currency will be available at a price determined when the future contract was purchased.
The most complete safeguard against unfavorable exchange fluctuations is, of course, enjoyed by marketers when payment is to be made in their domestic currency, but even then they have an interest in exchange fluctuations. Fluctuations following the closing of the sales contract may be so unfavorable that the foreign customer may refuse to accept delivery, or, having accepted the goods, may be unable or unwilling to meet the financial obligation. Thus, the exchange rate fluctuations may increase the exporter’s credit and commercial risks
The importer who has purchased foreign goods in terms of domestic currency may have an indirect interest in exchange rate fluctuations because losses resulting from exchange fluctuations may include the foreign seller to delay shipment or fail to make delivery of the ordered merchandise. Although the importer will not make payment and therefore will not suffer a direct loss from exchange rate fluctuations, business is disrupted and, if any of the ordered items has been resold in advance of its receipt, the importer cannot deliver.
Credit: Managerial Economics-MGU KTM