Last month, we looked at practical suggestions from event professionals for dealing with international currency fluctuations. In Part II, Dan Noot — whose career includes extensive experience in international business development — takes us step by step through currency conversion. Noot is co-president of Toronto-based Decor & More.
Let's explore the different economic outcomes of a sales contract denominated in a foreign currency. [Financial terms are marked in boldface type; you can find helpful definitions at www.investorwords.com.]
We'll assume the following:
Event Producer (“EventCo”) is based in the U.S.
Client is based in London and will pay EventCo £500,000 on event date, one year from now.
Current (i.e., “spot”) rate is: £0.50/USD (or $2.00/£).
The one-year forward rate is: £0.52/USD (also quoted as the reciprocal, or $1.9231/£) as quoted by a bank (“FinCo”).
(Note: Interpreting the rates, we see that the market expects the dollar to strengthen against the pound over the next 12 months. From the U.S. perspective, you will get £0.02 more per USD a year out than you can get today. From the British perspective, in 12 months a pound is forecast to be worth $0.08 less than its value today.)
There are several alternatives available to EventCo, including:
- Hedge using forward contracts.
- Hedge using currency options.
- Remain unhedged.
What approach is taken depends on several variables. First, what does EventCo believe the dollar will do relative to the pound? Second, how much risk does EventCo want to be exposed to; that is, could EventCo financially absorb a sizable exchange loss if the pound weakens? Third, does EventCo have cash on hand currently to buy a currency option?
1. HEDGE USING FORWARD CONTRACTS
If EventCo doesn't wish to take any risk, then the preferred approach is a forward contract. With forwards, you are committing to hand over a fixed amount of pounds in exchange for a fixed amount of dollars on a specific date.
In our example, if EventCo entered into a forward contract, management knows exactly how much it would be receiving in USD one year from now: $961,550 (figures are rounded off). The mechanics are as follows: One year from now (when EventCo collects from the client), EventCo would deliver £500,000 to FinCo, and FinCo (honoring the rate of £0.52/USD) divides £500,000 by .52 and arrives at $961,550.
With a forward contract, no matter what happens to the X-rate [the horizontal axis on the chart on this page, showing changing values of the USD to the pound], EventCo will receive $961,550 in one year.
2. HEDGE USING CURRENCY OPTIONS
What if EventCo wanted to limit the downside exposure while maximizing the upside potential to getting more dollars? As the old saying goes, “There's no free lunch,” and this is especially true in the world of international finance. To create this type of payout possibility, EventCo would purchase an option — specifically, a put option — which allows the holder of the option to sell pounds at a specific price, called the strike price.
To illustrate, EventCo wants the option to sell pounds one year from now at a price of £0.50/USD; that is, the option to sell £500,000 for $1,000,000. Options must be bought, so a premium is required. Let's say that a put option with a strike price of £0.50/USD can be bought by FinCo at a premium of 4 percent (or £20,000).
If a year from now the dollar strengthens and the X-rate is £0.54/USD, the sales proceeds would be $925,925 after conversion. However, with the option in hand, EventCo has the right to exercise its option at the strike price (£0.50/USD), providing $1,000,000. In this scenario, exercising the option would have provided value ($1,000,000 - $925,925 = $74,075) far in excess of the cost.
However, what if the dollar weakened against the pound during this time frame? Let's assume now that the rate one year out is £0.48/USD. The market value of the contract would be $1,041,666, so EventCo would not exercise its option. (Remember, the option provides only $1 million in gross proceeds.)
You can see from this example that although options can be quite costly, they allow you to limit your losses while giving you potential to realize currency gains.
3. REMAIN UNHEDGED
In the last section of the put option scenario above, we've already calculated market values under different future X-rate possibilities, and this helps to illustrate the unhedged approach. There is no limit to the gain or to the loss. Where there is risk, there's reward — and vice versa.
Readers should avoid the false sense of security that holding a stable currency provides. Every currency, at some point in time, has had at least one instance of extraordinary volatility, and these are extremely difficult to predict. In the past 24 months, the U.S. dollar, historically the preferred safe haven for international investors, has lost much of its status as the currency of choice.
WHAT TO DO?
Please see the graph on the preceding page, which illustrates the different levels of proceeds for each of the three alternatives discussed above.
The unhedged position gives you unlimited upside, yet could be quite ugly if X-rates move against you. Companies have had windfall cash while other firms have gone bankrupt simply due to having an “open” position in currencies.
The forward position is the flat line, as we discussed. Regardless where the X-rate goes, EventCo will get the same payout: $961,550.
The put option alternative limits your downside, but you have to pay for it through the 4 percent premium on the contract value. Proponents like options because they give you at least a minimum amount of proceeds with the opportunity for upside potential. Others dismiss options, not wishing to outlay cash today for something that may be “worthless” in the future. (Please note, this is faulty logic as options do carry economic value.)
KEEP IN MIND
Anyone with international transactions must realize that the only constant is change. The simple example above illustrated the revenue impact of operating internationally, but the true value needs to factor expenses also, particularly as professionals are contracting suppliers from around the world.
There is no single “one size fits all” solution for X-rate management. The appetite for risk needs to be measured, and honestly. People who have the tolerance for risk need to be clear on exactly how much risk they can carry.
Whatever the organizational appetite and philosophy, a strategy must be in place. Truly, it would be a pity to have an incredibly talented enterprise embarking on an international growth plan and having years of success, only to suddenly face bankruptcy because management didn't properly identify and manage its international exposure. And if it can happen to some of the world's biggest banks, it can happen to anybody.
Dan Noot invites Special Events readers with questions on global strategic planning and international business development to contact him at [email protected].