An Importer's Foreign Exchange Problem Solved

The Problem

A company imports from abroad and does not have to pay for the goods until they are sold on. Payments must be made in the currency of the supplier.  The problem with this is that the exchange rate at the time the goods have to be paid for is a future unknown.

If the company imports $2 million worth of goods, then there is a risk of the exchange rate falling and having to pay a higher price than  now.  Every 10 cent change in the rate could cost the company some £83,000.

The rate could, of course, go the other way.  The company might be happy to just let this risk run, confident that they can pass on the price increase, or perhaps judging that the dollar is weakening and sterling strengthening, so that on balance they are more likely to benefit from movements. Many, however, prefer a degree of certainty.  How can they achieve certainty when they cannot know what exchange rates will be ?

The Solution

Normally you would have a reasonable idea of when you have to pay for the goods, that is, the exchange rate liability will crystallise. You would buy the $2M forward on that date, paying today's rate adjusted for interest between now and then.  In doing so you would have 'fixed' the price you have to pay.

However, you don't know when you are going to have to pay.  Even though you do not know when the goods will be sold or what the exchange rate will be, fixing the exchange rate at today's price is easier than you might think.  Here is how.

Step One :  Buy the total amount of currency you will need by the end of the period, at the end of the period

To keep it simple, let us suppose that the goods are one single item of machinery.  This method works for continuous sales of low value  goods, but let's not complicate things just yet.  Here, you only know that you expect to sell the goods at some point over the next 15 months at most (say this is a slow stock turnover item, but necessary to hold).  So you know that after 15 months you will have a $2M liability if you were allowed to hold off payment until then.  So to fix your exchange rate, to 'immunise' the liability, you buy $2M 15 months forward.  Now you will own $2M in 15 months and have to settle for the dollars then.

Step Two:  Make a sale.  Buy the dollars to pay for the goods, sell them forward

Suppose the machine is sold after nine months.  You get an excellent price and the customer signs up for maintenance and ancillary services, plus seems likely to demand you technical service products in the future.  Everyone is very happy.  I just put that bit in to make you feel good.  The exchange rate has deteriorated terribly, but you are quite happy about settling the bill for the machine.  It is not a problem as you are hedged.

We are nine months into the fifteen month currency contract. It is September. You have sold the machine and have to settle for it in dollars.  You don't have any dollars - the ones you bought were for delivery  fifteen months later - so you have to buy $2M at the horrible rate reached in September.  You are quite relaxed about this, because you are hedged, of course.  On the same September day as you buy the dollars to settle with your supplier, you sell the same amount six months forward, ie.e on the same day in March next year that you have to buy $2M.  So now you have bought and sold $2M in September at a bad rate for paying.  However, you have also sold and bought the same amount of dollars for settlement in March next year.  The dollars you bought have to be paid for now at a bad rate for paying.  Against this, the dollars you sold will be settled in your favour next March at a great rate for selling.

Transactions

Step Three :  At the end of the forward period all transactions are netted off and settled

It is March. The 15 months are up. You have to pay for the dollars you bought forward at a good rate fifteen months ago, but receive value for the dollars you sold forward six months ago (sold at a bad rate for buying, which is a good rate for selling).  Although you had to pay more for your dollars back in September, you now have an offsetting profit to make up for it.

Credit for this solution should go to the very brainy Tim Cowper at The FD Centre.

Cash movements

See the download below for a worked example with more than just one sale.

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