Managing Currency Risk in Export: Invoicing, Forwards, Hedging

How exporters manage currency risk: choosing the invoicing currency, forward contracts with a worked example, options, natural hedging and contract clauses.

An exporter can do everything right, find the buyer, price correctly, ship on time, get paid in full, and still lose money because the exchange rate moved by 6% between the quotation and the payment. On a 10% margin, that is more than half the profit gone without anyone making a mistake.

Currency risk is the one export risk that hits even perfect transactions. The good news is that it is also one of the most manageable, with tools that range from free, choosing the right currency and matching costs to revenues, to standard bank products such as forward contracts.

This lesson explains where currency exposure comes from and when it starts, how to choose the invoicing currency, how a forward contract works and is priced, what options add, and how natural hedging and contract clauses protect a small exporter without a treasury department. The worked examples use an Algerian exporter, because selling in EUR or USD with costs in dinars is the textbook case of transaction exposure.

Where does currency risk come from?

Three kinds of exposure are usually distinguished:

• Transaction exposure: a specific receivable or payable in foreign currency whose value in your currency can change before it is settled. This is the one this lesson is about.
• Economic exposure: the longer-term effect of exchange rates on your competitiveness, for example a competitor whose currency has fallen 20% against yours.
• Translation exposure: the effect on your accounts of revaluing foreign-currency balances; an accounting matter rather than a cash one.

When does exposure start?

Exposure begins as soon as you commit to a price in a foreign currency, that is, when you send a quotation the buyer can accept. It runs through the order, production, shipment and the credit period, and ends when you convert the payment or use it to pay a cost in the same currency. On a deal quoted in March and paid 60 days after a June shipment, you are exposed for five months, not two.

How do you choose the invoicing currency?

For an exporter from a country whose currency is not convertible, such as Algeria, invoicing in the home currency is not realistic: the dinar is not used to settle trade abroad. Algerian exporters invoice in EUR, the main currency of their trade with Europe, or in USD, the norm for many commodities and for trade with the Gulf and Asia. The real choice is between those two, and the right one is often the currency of your main costs or debts, because that minimises the gap.

Forward contracts: fixing the rate today

A forward contract is an agreement with your bank to exchange a fixed amount of one currency for another on a future date, at a rate set today. It is binding on both sides: you must deliver the currency on the date, whatever the market rate.

How is the forward rate calculated?

A forward rate is not the bank's forecast. It is the spot rate adjusted for the interest-rate difference between the two currencies over the period: the currency with the higher interest rate trades at a forward discount. The simple formula, for a period t in years, is: forward = spot x (1 + quote currency rate x t) / (1 + base currency rate x t). The bank then adds its margin.

Worked example: appliances to Riyadh

An Algerian manufacturer sells household appliances to a distributor in Riyadh for USD 500,000, payable 90 days after shipment. Its components come from Italy and are paid in EUR; its total cost for the order is EUR 400,000. It wants to know how many euros it will receive.

1. Spot EUR/USD is 1.1000. At that rate, USD 500,000 = EUR 454,545, a margin of EUR 54,545.
2. Illustrative three-month rates: USD 4.0% a year, EUR 2.0% a year. Forward = 1.1000 x (1 + 0.04 x 0.25) / (1 + 0.02 x 0.25) = 1.1055.
3. The exporter sells USD 500,000 forward at 1.1055 and locks EUR 452,300, a margin of EUR 52,300.
4. In 90 days, whatever the market:

Unhedged, a move to 1.1600 cuts the margin to about EUR 31,000, a loss of more than 40% of the expected profit. Hedged, the margin is known from the start. The cost of the hedge is the EUR 2,250 difference between spot and forward value, plus the bank's margin, and the gain given up if the dollar strengthens.

Currency options: protection with upside

A currency option gives you the right, but not the obligation, to sell a currency at a fixed rate on a future date. You pay a premium upfront. If the market moves against you, you exercise the option; if it moves in your favour, you let it lapse and sell at the better market rate. Options suit uncertain flows, such as a tender you may not win, but premiums can be expensive for small amounts and volatile currencies.

Natural hedging: the cheapest protection

Natural hedging reduces exposure without a financial product, by matching inflows and outflows in the same currency:

• buy imported inputs, packaging or freight in the currency your buyers pay you in;
• keep a foreign-currency account and pay foreign-currency costs from it instead of converting twice;
• finance the export with a loan in the invoicing currency, repaid by the buyer's payment;
• net payables and receivables with the same counterparty or currency.

In countries with exchange controls, what you may keep and spend in foreign currency is regulated. Algerian exporters may retain part of their export proceeds in foreign currency under Banque d'Algérie rules; the share and the permitted uses are set by regulation and have changed over time, so check them with your bank. See repatriation of export proceeds.

Contract and pricing techniques

1. Use a budget rate in every costing: a prudent rate, for example the current rate minus a safety margin, so that a moderate move does not erase your margin. See export pricing.
2. Keep quotation validity short, 15 to 30 days, and state that prices are firm only on order confirmation within that period.
3. Add a currency clause for long contracts: if the rate moves more than an agreed percentage between contract and payment, the price is revised, or the loss or gain is shared.
4. Shorten the exposure: ask for a deposit, invoice promptly, and consider discounting the receivable to convert earlier. See trade finance.
5. Set a policy: decide in advance what share of confirmed receivables you hedge, from what amount, and who decides. Hedging every deal by instinct is speculation in another form.

Common mistakes

• Pricing in foreign currency with today's spot rate and no safety margin.
• Thinking exposure starts at shipment, when it started at quotation.
• Hedging an amount larger than the confirmed receivable, which turns protection into a speculative position.
• Choosing USD to "follow the market" when all your costs and debts are in EUR.
• Forgetting the cost of converting twice, from USD to local currency and back to EUR for suppliers.
• Comparing a hedged result with the best rate after the fact: the purpose of a hedge is certainty, not the best price.
• Never checking, after payment, what the exchange rate actually did to each shipment's margin. See tracking shipment profitability.

Putting it into practice

On Incoforms, shipment costing records the revenue in the invoice currency and each cost in its own currency, converted with the exchange rates of your multi-currency accounts. The shipment's risk score includes exchange-rate exposure, and the what-if simulator lets you test a different rate, for example your budget rate or a 5% move, and see its effect on the margin before you send the quotation.