Increasing profit margins on foreign deals by using currency hedging.
Increasing profit margins on foreign deals by using currency hedging.
Currency futures -- an often-overlooked way to fatten profit margins on foreign deals
Mention currency hedging to most business owners and their eyes glaze over. Not Buddy Tell. The owner and president of Textile Import Corp., a New York City importer of high-quality fabrics for clothing manufacturers, relies on hedging techniques to keep his prices low while squeezing out every last dollar of profit.
Put simply, by using currency hedging, Tell, whose company has sales of some $25 million a year, negotiates deals in the local currencies with mills in Italy, Japan, Germany, and elsewhere. Then he protects his company against international economic volatility by buying currency-futures contracts. They guarantee him the right to trade U.S. dollars for those currencies at a specified rate at some future date, usually when his suppliers' bills become due.
Why go through the hassle? "I always negotiate better prices from the mills because I'm willing to deal in their currencies," he says. "If I insisted on the mills accepting U.S. dollars from me, then they'd have to factor in their additional cost for changing the dollars into their own currencies."
Although Tell is strictly an importer, the same logic holds true for U.S. companies that export their products. If U.S. exporters accept payment in foreign currencies and exchange them for U.S. dollars, they can almost always charge higher prices for their products.
"People might worry that the cost of buying or selling currencies would eat up those higher profit margins, but it doesn't work that way," says Tell. "If you're smart about the way you handle your currency transactions, you can keep trading costs down to a minimum."
Being smart means planning ahead. "I could wait until the day before I needed the foreign currency to pay for my delivery and then just call up a trader and buy what I needed, but that would be gambling," says Tell. That's because if the dollar drops in value from when he places the order until he actually changes the currency, buying the currency would wind up costing his company more money than anticipated, which would erode profits. "I'm a businessman, not a gambler," he says. "I won't risk losing profits if currency fluctuations go against me."
Tell minimizes those risks and protects his profit margins. The moment he enters negotiations for an order with a foreign mill, he starts researching the currency market to figure out just how much it would cost him to lock in an agreement that day. (It's called a futures contract because the actual transaction occurs in the future, at a time when his suppliers will be ready to deliver their products.) "If I'm going to need one million Japanese yen 90 days from now, I want to know exactly how much it's going to cost me," he explains, "because then I can factor that into the final price I negotiate with the mill, to guarantee my profit margins."
Currency futures operate just like any other futures contract. When you sign a contract, you commit to paying the agreed-upon price regardless of what happens to real-world prices by the time the contract becomes due. However, Tell isn't overly concerned if from time to time he winds up paying more than he would have had to if he had waited until the last minute. What really matters to him is the predictability of costs. "My currency-trading costs aren't different to me from any other cost of providing my product," he says.
It pays to shop around for the best futures price you can find on every deal. "The currency market isn't at all like the stock market, where there's one fixed price for IBM's shares or other companies' shares at a particular time, wherever you buy them," says Tell. "The price you pay for a contract can differ tremendously based on which bank you're dealing with, what their currency supplies are like at that particular moment, and how valuable a customer you are to them."
That's the nature of the currency market. Banks and other currency traders earn profits according to the spread -- the difference between the price they pay to buy a foreign currency and the price at which they can sell it to you. Generally speaking, those traders save their most favorable rates for the companies buying futures contracts that are worth more than $1 million. Because Tell's deals usually range between $100,000 and $500,000, he has discovered that it pays to compare prices from at least three different banks before settling a deal. (See, "Resources," below.)
The more executives know about the price levels of the currency market, the better the trading price they can usually negotiate. Unfortunately, staying up-to-date on prices can be next to impossible for smaller companies, since they lack the resources to hire someone to sit in front of a computer all day and track the fast-moving $650-billion-a-day currency market. ( The Wall Street Journal does run a daily listing, but it's not very helpful for most smaller businesses because it reflects prices charged to the largest customers at one particular moment -- 3:00 p.m. on the previous day -- for what are known as "even date" contracts, which are those agreements dated one, two, or three months in the future. "If you've bought a contract for two and a half months from now, the prices that the newspaper lists aren't even accurate," Tell complains.)
"I've seen prices swing wildly just during the minutes that I'm on the phone with a trader negotiating a contract," says Tell. "And unless you've got somebody following those prices all day long by computer, there's no real way to tell at the end of a day whether you have negotiated yourself the best price possible."
Fortunately, although the currency market is complicated, the trades themselves are anything but, which means that Tell and other importers and exporters can carry them out while still leaving themselves free to devote most of their time and attention to customers and suppliers. "On a typical order, I might know that I'll need $300,000 worth of Italian lire on roughly three dates over the next three months, because my supplier will invoice me three separate times. So I'll call around to get some currency-trading estimates and then finalize my own deal with my supplier to include those costs," he says.
Because Tell knows that his foreign suppliers are not always as predictable about scheduling delivery as he might like, he usually chooses an option that permits him to conduct the currency trade anytime within the month specified. As soon as he approves a contract, he receives written confirmation of its terms. Then no money changes hands until the actual transaction takes place.
At that point Tell transfers his dollars to the bank with which he has contracted for that particular order. When the bank receives his funds, it changes them into foreign currency and wires the money directly to Tell's foreign bank accounts or to the bank accounts of his foreign suppliers, as directed. Although he has had his occasional mishaps -- such as currency deliveries that never arrived because of bank mistakes -- Tell remains convinced that it pays to add this extra step to his import deals.
"I've got competitors to worry about both in the United States and abroad," Tell explains. "And if I don't use currency transactions to my own advantage, you can bet that they will."
How to hedge with currency
Whether you're an experienced or novice importer or exporter, it pays to investigate the currency market. This is what you should do to begin:
* Pay for predictability. To minimize your risk from foreign economic volatility, lock in your currency-conversion costs with a futures contract hedged on each side with an option to trade at any time within the month of the maturation date for the transaction.
* Keep your product price list flexible. When calculating prices and profit margins on each deal, be prepared to factor in your current trading costs. Every time you negotiate a price, keep in mind the present currency exchange rates, so you earn your desired profit margins.
* Polish up your financial statement. Since futures contracts are a form of credit obligation in which your company promises to pay bankers a specified sum at a specified date, bankers will sell contracts only to companies whose financial statements look healthy. If bankers don't want your business, you may be able to buy currency-futures contracts from a brokerage house instead, but they will be far most costly, since you'll have to use a margin account to finance them.
The right trader
Growing companies need a currency trader that will provide technical support, trading advice, and cost-effective deals. But, as Textile Import Corp.'s Buddy Tell has found, if you simply call around to banks when you have orders of less than $1 million, you're likely to get shunted off to junior traders offering less than appealing rates. "You have to develop a relationship," says Tell. "Some bankers won't give a small-business owner the time of day if you call with questions rather than an order."
Recently Tell solved the problem by taking most of his business to International Monetary Exchange Inc. (IMEX), a currency representative in Elizabeth, N.J., that aims to provide smaller companies with the same favored-customer treatment banks normally reserve for larger importers and exporters. Because IMEX brings big blocks of business to banks, it can usually negotiate rates that are 3% to 5% less than those entrepreneurs can find independently. Its fee typically is about 20% of what clients save by using IMEX instead of a bank for contracts of $100,000 or more.