AMTEC, Inc. is a hypothetical computer software company located in Atlanta, Georgia. Its latest product, DOWUPLOAD, is designed to make it easy for office microcomputer users to gain access to databases stored and run by large mainframe computer systems. The president of AMTEC, Dunken Sharp, realizes that he must tap the international market. So he takes a trip to London. He knows London rather well, for he attended a summer-abroad program there some time ago.
As Sharp is explaining his program to some old London chums in a pub on Goodge Street, his friend Sean O'Malley interrupts him: "You know, that program would be perfect for my chaps at the office. They have been complaining that they just can't do the job I've given them. They have to use the city's largest databases to estimate the square yardage of old houses so that we can determine how much to import of the various materials we use in renovating them. I'm telling ya, mate, your program will save me a lot of money."
Upon returning to Atlanta, Sharp calls in Jim Young, AMTEC's sales manager, and says, "Jim, I've made my first sale to the U.K. Ship the order and bill my friend 90 days net, just like all our good customers. We agreed on a price of 3,000 British pounds."
During lunch Sharp tells a banker friend how easy it is going to be to export the new computer software package. He thinks that the deal he made with Sean opened the door.
His friend says, "Listen, I really hate to tell you this, but we at the bank don't think much of the pound. I personally think that by the time you get your 3,000 pounds you'll have lost quite a lot on the deal."
"I don't understand," says Sharp. "He's my good friend."
"No, no, I don't mean that Sean isn't going to pay you. No doubt he will. What I mean is that when you bring the 3,000 pounds to the bank for deposit they aren't going to buy you the dollars that you expect. The pound has been depreciating drastically. A week ago the rate was $1.660 to a pound. Today it's down by as much as $0.30. For 90 days it sells at a hefty discount. Let me protect your exposure. Why don't you send over your accountant or sales manager and let me take care of this for you."
What are AMTEC's options for avoiding losses from currency fluctuation? Table 12.1 summarizes the main tools available to lessen AMTEC's transaction exposure. Internal group/ company tools refer to the ways a firm can change its own credit and payment procedures to minimize its exposure. External group/ company tools refer to contractual arrangements that can be made with outside organizations, such as banks and other financial institutions specializing in international financial services.
Forward, or exchange market, hedging is the technique most commonly used to minimize transaction exposure. It is the most appropriate tool for a small company that is new in the international business game. A forward contract is an agreement between an importer or exporter and a third party, such as a bank, in which the former promises to deliver a certain amount of foreign currency to the latter on a specified future date in return for a fixed amount of another currency. In AMTEC's case the company and the bank would sign a contract stating that in 90 days AMTEC will sell 3,000 pounds for a stated number of dollars.
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Internal Group /Company Tools
External Group / Company Tools
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| SOURCE: Oxelheim and Wih lborg , Macroeconomic Uncertainty © 1987 by John Wi ley & Sons, Ltd. Reprinted by permission of John Wiley & Sons, Ltd. |
Why should the bank get involved in a contract of this nature, knowing full well that the pound may depreciate or the dollar may appreciate? The answer is, of course, that the bank will make a commission. AMTEC's protection from the depreciation of the pound will cost it some money. Being "risk-averse," the company is willing to pay money to ensure against possible decreases in the dollar value of the 3,000 pounds in accounts receivable.
The amount of money the bank charges AMTEC will depend on the difference between today's exchange rate (the spot rate) and the exchange rate for currency to be delivered 90 days from the date on which the contract is signed (the forward rate). When the forward rate is higher than the spot rate, the pound is said to be selling at a premium. In the opposite case, the pound is said to be selling at a discount.
Credit, or money market, hedging is much simpler than forward hedging. A company wishing to protect its cash flow from exchange rate fluctuations simply takes out a bank loan in the foreign currency and then immediately converts that money into local currency, which is either deposited or used. In the case of AMTEC, the company would borrow 3,000 pounds from the bank at the spot rate, convert them immediately into dollars, and then either deposit the dollars in the bank or use them to increase its working capital. AMTEC is then protected against any exchange rate fluctuations, since it can simply use the 3,000 pounds in accounts receivable to payoff the loan principal. Should the pound depreciate to the point where the decrease in the dollar value of 3,000 pounds exceeds the cost of borrowing from the bank (the interest), AMTEC will have made a smart move. If the pound appreciates, AMTEC will have spent money on interest unnecessarily.
Should AMTEC do nothing, borrow, or use the forward market? It all depends on the anticipated magnitude of the exchange rate fluctuation, the likelihood of fluctuation, the cost of hedging in the forward market, and the cost of borrowing in the credit market.
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