3 min read International trade, known in its earlier form as mercantilism, dates as far back as the Middle Ages. While the concept has remained steadfast, international trade has evolved with, and is influenced by the complexities of today’s global economy.*
Competing in a global market
Buyers of foreign goods today have to contend with the macroeconomic risk factors of currency exchange. The world market includes 180 currencies, many of which are valued based on interest rates, geo/political circ*mstances, capital flow, and money supply.
Every international cross border transaction carries with it Foreign Exchange (FX) risk, which is the possibility of losing money due to unfavorable moves in exchange rates. There are ways to mitigate FX risk, for example U.S. buyers looking to lower the price of the goods or services they are buying from abroad should consider getting a quote in both U.S. Dollar (USD) and the currency of the supplier. The U.S. buyer can then compare the cost of paying in the supplier’s currency in USD terms vs the USD quoted.
Navigating a fluctuating USD
Before solidifying the deal, there are factors to understand about USD. Just like the rest of the world, the USD is subject to variables which affect its value relative to other currencies. In fact, in July 2023, the USD dropped to a 15-month low following a cooler-than-expected Consumer Price Index (CPI) report. Meanwhile, the Euro, Pound, and Yen all notched robust returns as inflation remained a more pressing concern. Refer to the chart which shows the USD Index (DXY), an index of the value of the United States dollar relative to a basket of foreign currencies, which shows an eight-period decline since 1989.
Managing FX risk
U.S. buyers of internationally produced goods or services may decide it is easier to price their contracts in USD. However, in doing so, they are actually shifting the FX risk to their supplier due to market volatility. All U.S. buyers must realize that the supplier’s cost of goods sold (COGS) and margin are at risk with a deterioration of the USD against their currency.
Using the Euro against the USD as an example illustrates how currency volatility can change over time. Over the last 90 days Euro volatility has been 7.9%, at 180 days it’s been 15.7% and at 1 year its 19.4%.
In terms of FX risk, this means that European suppliers pricing in USD will add the appropriate percentage to their USD prices between the time when they price the contract and when they anticipate payment.
To demonstrate, a USD sale worth USD $100,000 today, but payable in 90 days would see the price increase to USD $107,900 (7.9% increase); payable in 180 days USD $115,700 (15.7% increase; and payable in one year USD $119,400 (19.4% increase).
How can you potentially avoid paying more for imports and losing money on your exports?
FX risk is normally priced into the transaction if the seller of the goods or services is required to bill the U.S. buyer in USD. Using the previous example, by using a Foreign Exchange Forward contract that coincides with the term between negotiated price and ultimate payment date, the U.S. buyer can negotiate the purchase in Euros, thereby mitigating the risk and ensuring the sale close to the stated USD $100,000.
Tom Stapleton
SVP Foreign Exchange
Questions?
You may direct questions or comments about this message to your commercial banker or the FX Trading desk 716-842-5118
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