In today’s global economy, businesses should consider sourcing and selling in foreign markets to grow.
Whether your company is a subsidiary of a foreign company or a U.S.-grown business looking to expand overseas, it is important to learn the alternatives to structuring foreign payments and receipts. Here are some key considerations for managing your company’s finances in a foreign country.
First, it’s important to address the question of whether you should transact with foreign counterparties in U.S. currency or the counterparties’ local currencies. Many companies believe they can eliminate foreign exchange (FX) risk by conducting international transactions in their own currency. Unfortunately, the truth is that FX volatility risk between two currencies is always present. By transacting in their home currency, companies end up passing on the FX risk to their suppliers — many of whom will charge a premium for assuming the risk or may fail to manage the risk appropriately. I suggest considering transacting in the foreign currency to avoid this and other problems. Here are some benefits associated with purchasing in local currency instead of U.S. dollars (USD):
• Reduce costs – When a supplier invoices in USD versus a local currency, the supplier assumes all of the exchange rate risk and may increase their prices in USD to protect themselves from currency market movement between the invoice and payment date.
• Visibility into FX rates – Obtain competitive exchange rates from your bank and know the exact amount of foreign currency paid to suppliers.
• Negotiate more favorable payment terms – Payments in foreign currency typically have a faster credit posting to beneficiary accounts.
What if you’re sourcing from a related entity, such as a parent company? In that case, it is still important to consider where the exchange rate risk lies and which party to the transaction is best suited to manage it.
Second, companies who sell internationally may also prefer to accept payments from customers in USD. Selling internationally in USD means that products and services become more expensive in a stronger dollar environment, and you may run the risk of losing business to local competitors.
Once your international payments strategy is in place, the next step is to determine the appropriate type of foreign exchange transaction, which falls into two primary categories: spot and forward contracts.
• A spot contract is a legally binding agreement to sell one currency and buy another on the nearest, standard settlement, or value, date. In other words, this is a ‘buy now, pay now’ deal at the current market exchange rate.
• A forward contract is a legally binding agreement to buy one currency and sell another at a rate agreed upon today. In other words, forward contracts are ‘buy now, pay later’ products, which enable you to essentially lock in an exchange rate at a set date in the future. The advantages of forward contracts include choosing a rate which is acceptable for your business and managing and budgeting cash flow without worrying about future FX volatility.
As the FX market evolves, new solutions continue to be introduced. One recent innovation is the introduction of a guaranteed FX rate program. A spot rate is based on the prevailing market rate two days before settlement, and a forward rate is based on the prevailing market rate for a specific FX amount and settlement date in the future.
Finally, an alternative approach to mitigating an exchange rate risk would be to open a foreign currency account. This is an ideal solution when a customer is selling and purchasing a product in the same currency. By using a foreign currency account, a company effectively protects itself from currency volatility for any amounts where the volumes of the receivables match the company’s anticipated payable needs.
With guidance and planning, you can decide how best to manage your out-of-country assets.
Philip Shober is senior vice president Central Pennsylvania, commercial banking at Bank of America Merrill Lynch.