If Only the World Was Really Flat: Mitigating Payment and Foreign Exchange Risk When Selling Overseas

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U.S. companies are increasingly looking to foreign markets for new sales opportunities, which can be challenging but rewarding if you are properly prepared for the risks involved. Understanding the risks associated with entering new markets and gaining the knowledge necessary to mitigate those risks can help you grow your business successfully overseas.

Methods of Payment 

The typical international methods of payment include open accounts, documentary collections, letters of credit and cash in advance. Table 1 can help determine which method of payment should be negotiated into a sales contract.

* Confirmation by U.S. or other world class bank suggested

Open Account 

In an open account trade arrangement, the goods are shipped to a buyer without guarantee of payment. Unfortunately, it's not uncommon for the buyer to avoid paying by the specified due date. This trade arrangement is risky to the seller due to the likelihood of non-payment on invoices.

Cash in Advance 

This is the safest form of payment for the seller. The seller receives payment before the merchandise is shipped to the buyer, therefore the seller assumes no risk. However, the seller may lose customers because competitors are often willing to agree to more flexible payment terms.

Documentary Collection 

A seller will usually agree to receive payment on a documentary collection basis when the buyer's creditworthiness and home country represent relatively few risks. Documents controlling the merchandise are forwarded through banking channels and are surrendered to the buyer upon agreement to pay or accept the seller's draft.

Commercial Letter of Credit for Export 

This method of payment is an irrevocable commitment by a bank to pay the seller when proof of shipment documents are presented to the issuing bank. The issuing bank substitutes its credit for that of the buyer, thus assuring the seller that payment will be made by the bank provided that the terms and conditions of the letter of credit (LC) are met. If the LC is "confirmed" by a U.S. bank, the U.S. bank assumes payment to the seller, thus eliminating the foreign bank and country risk associated with an unconfirmed LC. This method of payment provides the seller the lowest level of commercial and political risk and is commonly used when selling to Asia.

Assessing Foreign Exchange Risk 

With proper foreign exchange (FX) risk management, sellers can reduce potential exposure to sudden movements in exchange rates. Most companies have common FX goals including securing profit margins, fixing future cash flows and improving or stabilizing financial performance.

Finance professionals want to avoid explaining to the board members and shareholders that the company failed to meet earnings estimates due to an adverse movement in the U.S. dollar. FX markets can be volatile in the short- to medium-term. While factoring in exchange rate predictions, it's important to note that even FX strategists are right about 60 percent of the time.

For many companies, foreign exchange exposure is difficult to understand and manage, given its complexity and the time required to effectively stay abreast of daily currency fluctuations. Unfortunately for many firms, they do not determine the need for a policy to hedge foreign exchange exposure until losses have become material.

Identifying Exposure 

There are three common measures used to identify the most common financial risks associated with sales overseas: transaction exposure, translation exposure and economic exposure. In order to determine your risk exposure, ask yourself questions such as, "What currencies are the accounts payable and receivables denominated in?" or "Where are our subsidiaries or foreign offices located?"

When determining transaction exposure you want to identify potential changes in the U.S. dollar value of outstanding foreign currency financial obligations between the time the transaction is entered on the company's financial statements and the time the actual cash payment is made. The greater the time differential between entering and settling a transaction, the greater the transaction risk, since there is more time for the exchange rates to fluctuate.

Translation exposure results from the conversion of foreign currency financial statements into U.S. dollars for financial reporting purposes. This occurs when portions of the firm's assets, liabilities and equity are denominated in a foreign currency.

Testing economic exposure helps a company measure the change in value of the firm, resulting from changes in future operating cash flows caused by an unexpected change in exchange rates. This is considered a longer-term exchange rate risk that could adversely affect future sales volume, prices and costs.

The Basic Tools to Help Mitigate Foreign Exchange Risk 

• Spot TradesThese contracts are used for exchanging currencies within one or two business days.
   
• Forward Contracts
  Forward Contracts set the exchange rate today, but settle on a future specified date, typically one to three months after the transaction date. Forward contracts help eliminate the uncertainty in profit margins that result from exchange rate fluctuations. These types of contracts are the most common instrument used to protect future foreign currency cash flows.
   
• Forward Window ContractsThese contracts are similar to forward contracts, but have the added flexibility of choosing a range of dates for delivery rather than one specific date. These instruments are suitable for future transactions that have no exact settlement date. The most common length of a forward window contract is 30 to 90 days.
   
• OptionsOver-the-counter options provide the right, but not the obligation, to buy or sell a foreign currency at a predetermined exchange rate (strike price) in the future. By paying an upfront fee (premium), an option acts as an insurance policy by allowing the buyer to deal at "no-worse-than the strike price." The potential loss is thus limited to the premium paid. The advantage is that if the exchange rate moves in your favor, you can let the option expire and purchase the currency in the spot market. Purchasing an option is particularly useful to hedge an uncertain exposure – such as tendering a contract overseas – since there is no obligation to take delivery of the currency.
  
  If an adverse move on exchange rates is going to have a material impact on the income statement or balance sheet, this is the appropriate time to address the foreign exchange risk. Other areas to consider when managing your FX exposure are accounting and Sarbanes-Oxley related to hedge documentation and internal controls. While all of these issues may seem taxing, it is important to hedge a portion of your exposure to mitigate your overall risk.

Overwhelmed? 

Despite seemingly daunting financial risks, opportunities for success and sales growth overseas are unmistakable. It's wise to consult with a banker or financial advisor early in the sales process. Whether you are a large or small company, the list of products and solutions that are available to assist you in mitigating your international risks are immense and flexible to fit any size company or situation. Many banks have a group of global financial advisors that work with the company's management team to educate and assist clients with global expansion. With the appropriate level of attention paid to identifying and mitigating financial risks abroad, companies have every opportunity to take advantage of sales opportunities in burgeoning markets around the world.

Resources to Determine Risk 

There are numerous resources you can turn to for assistance when determining the commercial or political risks associated with selling to various governments or international companies. The following is a list of resources and services providers, both public and private, that can help mitigate foreign risk.

Commercial Credit Risk Resources 

Public
U.S. Department of Commerce "Doing Business In" Guides
http://export.gov/about/eg_main_016806.asp
 

Private
Coface North America, www.coface-usa.com
Dun & Bradstreet, www.dnb.com
GraydonAmerica, www.graydonamerica.com 

Political Risk Resources 

Public
CIA World Factbook, www.cia.gov/cia/publications/factbook 

Private
Dun & Bradstreet International Risk and Payment Review, www.dnbcountryrisk.com
Coface North America, www.coface-usa.com