Final installment of a three-part series exploring the use of swaps, asset-based lending and foreign currency exchange to balance business risks and find opportunities.
Like many businessmen, Peter Brust starts each morning by checking stock market prices and, most importantly, the foreign exchange market. He is most interested in euros, particularly the almost constant fluctuation in the value of euros against the dollar, and can quote from memory historic rates.
“We were paying $1.35 to $1.37 for euros for the first two quarters of 2015,” he said. “Now they’re around $1.08 to $1.12.”
Brust is not a currency trader. In fact, he doesn’t want to be one. “It might be fun until the pressure gets to you,” he said. But in his role as director of accounting and finance for John Matouk & Co., a Fall River producer of fine linens and luxury bedroom and bath items, he oversees the purchase of hundreds of thousands of euros each quarter and the selling of an equivalent amount of U.S. dollars.
Many of the company’s overseas vendors insist on being paid in their native currency, usually euros, and Brust’s job is to try and reduce the impact a fluctuating euro-to-dollar rate will have on his company, which in 2015 had $25 million in sales.
So, while 120 employees in the company’s beautiful new facility are manufacturing products with raw materials from all over Europe, Brust is carefully “hedging” against the moving foreign currency by locking in rates that allow him to meet Matouk’s budget and profit expectations regardless of where the rates go.
“We only have the ability to reset our prices once a year,” he said. “So, the estimate that we make in the beginning of the year about foreign currency really does have impact on our business.”
The currency rates, highly sensitive to world events, may currently be the most volatile in history. An economic slowdown in China, falling oil prices, a sliding Dow Jones Industrial Average, and a rising dollar can all contribute to major swings in the currency rates. They all command Brust’s attention.
They also set Kim McKenna’s phone buzzing.
“When volatility is rampant, we get more calls,” said McKenna, director of foreign currency exchange at Rockland Trust. “I guess volatility is good for our business, but it’s stressful for our customers and their businesses.”
The businesses McKenna and her department deal with aren’t multinational corporations involved in massive currency trading and exchanges. They run the gamut, from the small independent firms that produce educational software, for example, to major equipment manufacturers and importers.
“I would say about 90 percent of the bank’s business customers today are doing something internationally,” said McKenna. “We work with high tech companies, shoemakers, equipment manufacturers, even a company that imports carrier pigeons. Nearly every company today has an international presence.”
The U.S. Department of Commerce said there were 10,709 companies in Massachusetts engaged in exporting in 2013, and Bay State exports totaled $27.5 billion in 2014.
Some company owners, McKenna said, hadn’t even considered the machinations and risks of overseas buying and selling when they went into business. They have come to rely on her and her department for guidance, advice and risk mitigation that far and away surpasses the simple swapping of one currency for another that her job title might suggest.
“Many find themselves in situations not knowing what to do,” she said. “We give them solutions, or maybe several possible solutions, when analyzing the current environment.”
The options for companies involved in international transactions are myriad and often complicated:
“They’re in the business of making and selling products,” McKenna said. “They don’t want to get bogged down in analyzing the risks. That’s what we do.”
Understanding challenges and risks
A simple example illustrates the challenges of selling overseas. Suppose an American company sells equipment to a buyer in France for €1 million (1 million euros). The equipment is scheduled to be delivered 90 days before the payment is made. At the time the sale was made the exchange rate was €1.25 per dollar.
At that rate, the company could expect to earn $1.25 million in gross revenues from the sale. Figuring its production and delivery costs at $1.15 million, the company could book a profit of $100,000.
However, before the company received payment, the value of the euro fell to €1.10 against the dollar and that profit became a $50,000 loss.
Of course, if the American company required the French company to make the payment in dollars instead of euros, the French company would bear the risk of euro to dollar fluctuation. But it doesn’t always work like that.
“We have several companies that sell overseas and the foreign company insists on paying in their currency,” said McKenna. “They make it a contractual obligation and that often times increases uncertainty and anxiety about where rates are going.”
To mitigate the risks associated with currency exchange many customers turn to “hedging.” Hedging is done by buying or selling foreign currency for delivery or settlement on a specific future date at a predetermined exchange rate.
“You can limit, reduce and even eliminate the risks of fluctuating rates so that element of volatility is gone,” said McKenna.
For example, 3D Incorporated, located in Weymouth MA, makes 3D printers. They import some of the parts from a company in Germany. That company invoices them in euros. Realizing the volatility in foreign exchange markets, specifically the euro, the company wants to protect its profit margin. So it enters into a hedge once a month for the euro payables. 3D has agreed to pay the German company €1 million in 60 days. So it immediately buys euros and sells US dollars with a forward contract. It locks in an exchange rate of €1.10 euros to the dollar, which will cost it $1.1 million. At this point, 3D doesn’t have to worry about the foreign exchange volatility and their profit margin is protected.
If it didn’t hedge its exposure and the euro moves just two percent, the company would have to pay $1.122 million, $22,000 more than planned.
The advantage to the hedge is that rates are locked in and there’s no guesswork or risk in losing money should the value of euro plummet. Of course, the company gives away any upside potential should the euro’s value against the dollar increase, but McKenna says most firms are more interested in simply mitigating the downside and not in playing the currency markets for gain.
“The customer has to make the decision,” she said. “If they want to keep the risk, they can. I just tell them what I’m hearing, what I’m seeing, and what the various options are.”
A recent national survey of US corporations showed that companies engaged in currency hedging saved anywhere from 10 percent to 15 percent a year on their bottom line.
That’s pretty much in line with what John Matouk & Co. saves from hedging, an estimated 17 percent last year, according to Brust. The company projects and budgets its euro purchases quarterly, rather than tying their purchases to specific vendor invoices, he said.
“So, if we were going to buy €10,000 and our budgeted rate is $1.15 [per euro], we might get a forward contract from Rockland Trust for $1.10 and lock in that rate at better margins than we expected,’’ said Brust. “So the rate might go to $1.20 or it might go to $1.05, but all we care is how we bid against our budgeted rate.”
Currency fluctuations can affect businesses in many ways. Even if a US company doesn’t compete on the international market, it can still be subject to a risk because the price of its foreign competitor’s products may be affected by a change in the exchange rate. In order to effectively compete, the US company might have to lower prices.
“Volatility has been so great lately, there are companies out there that could be doing very well, or very poorly, depending on whether they are importing or exporting, even if they are not hedging,” said McKenna. “But with these huge swings, they might sleep easier by hedging.”