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Selection Of Currency And Hedging Strategy In Global Supply Management

Author(s):

Richard Locke, Jr.
Richard Locke, Jr., Principal, Global Procurement Group, San Francisco, CA 94114, 415/695-1673.
Jimmy Anklesaria
Jimmy Anklesaria, Principal, Anklesaria Group, Del Mar, CA 92014, 619/755-7119.

79th Annual International Conference Proceedings - 1994 - Atlanta, GA

ABSTRACT
The best choice of the pricing currency used in international procurement is a function of the product being purchased and the country where it is manufactured. In cases where the best currency is not the U.S. dollar, hedging is required. The best choices for hedging strategy are described. A strategy of actively choosing a hedging mechanism based on predicted dollar values is recommended.

THE ISSUE
U.S. purchasing departments are at a disadvantage compared to their more sophisticated counterparts in smaller countries, who deal in foreign currencies as a matter of course. A recent survey indicates that only 24% of U.S. international buyers are willing to negotiate in foreign currencies more than 25% of the time. U.S. buyers' unfamiliarity in dealing in foreign currencies leads to higher costs in two ways. First, they attempt to put all currency risk on the supplier, which causes the supplier to include charges for hedging, or to add an extra margin for contingencies into the price. Second, in an attempt to avoid dealing in foreign currencies, buyers use suppliers' U.S. subsidiaries and representatives, who will accept payment in dollars, but who also charge high markups.

Purchasing education and training neglect this issue, and often suggest that simply buying in dollars is the safe course. Corporate finance staffs are often unfamiliar with foreign currencies, and are concerned about headlines describing huge losses incurred by companies that speculate in currencies. Many MRP and purchasing information systems only accept one currency, making foreign currency pricing difficult to maintain and control.

THE SOLUTION
Buyers and finance staffs should understand when to buy in foreign currencies and when to buy in U.S. dollars. They should know the measures to take to avoid major increases in dollar cost and to be flexible enough to get decreases when possible. They should understand methods of reducing short term risk through hedging. They should have analytical tools available to help them choose between various hedging strategies.

CURRENCY SELECTION
The biggest advantage comes from the choice of the best pricing currency (the currency in which prices are set.) The payment currency (you may actually pay an equivalent amount of a different currency) does not make a big difference in prices. To choose a pricing currency, you must answer two questions.

First, what are you buying? Product prices can be divided into cost driven and market driven categories. Cost driven prices are those where the supplier can set prices based on his/her costs. Market driven prices are those where prices are set on a world market, usually in U.S. dollars, and the supplier can not sell at a higher price.

Second, where is the product built? Some countries have currencies that are pegged to the U.S. dollar. Other currencies float freely. If a currency is truly pegged to the dollar, there should be no need for currency protection.

FLOATING CURRENCY, COST DRIVEN PRODUCT
These products are typically custom or semicustom products. An example would be a printed circuit assembly from Japan or Europe. By pricing in the supplier's currency, you relieve the supplier of currency risk. This should enable you to negotiate a lower initial price than if you ask the supplier to take on the risk. It is better to start with the lower price, because you don't know if the dollar will strengthen or weaken. You can protect yourself against dollar cost increases by low cost hedging, and you need an escape clause in your purchase agreement.

FLOATING CURRENCY, MARKET DRIVEN PRODUCT
These products are typically commodities whose price is the nearly the same anywhere in the world. Examples are gold, oil, and DRAMs. For this type of product, you should not hedge. You are better off negotiating one world-wide price and maintaining the price the same around the world. This works best if you have purchasing presence in various regions, so that the lowest cost region becomes the norm for the next pricing round. Hedging does not work as it does with cost driven parts. If the dollar strengthens, the price in another currency goes up. If you hedged the value of that currency at the weaker value, your dollar cost will go up, not stay the same, when the dollar strengthens.

PEGGED CURRENCY, COST DRIVEN PRODUCT
Countries with pegged currencies are generally smaller countries. They include Taiwan, Thailand, Hong Kong and Korea. There is little need to hedge these currencies, because they are unlikely to move against the dollar. In addition, the foreign exchange market is thin and not well developed. Instead of hedging, you should have an escape clause in your contract, because these currencies do make occasional controlled changes in value against the dollar.

However, these countries import a lot of the material that they use to build assembled products. Often only labor and overhead is denominated in the supplier's national currency. A product from Taiwan may have a high content of Japanese products in it. If this content is really significant, you should hedge the yen (or European currency) content of such products.

PEGGED CURRENCY, MARKET DRIVEN PRODUCT
If the market is dollar based, these products need not be hedged. Similar techniques to those used for market driven products from floating currency countries are the best choice.

HEDGING
Hedging protects the dollar value of a future foreign currency cash flow. The reason to hedge is to protect yourself against major swings in the value of a purchase. You can achieve this via forward or future contracts or via currency options. As a buyer, you would enter into contracts to sell dollars for foreign currency at the time that you would pay the supplier. It's easiest to think in terms of using the foreign currency that you bought in the hedge to pay the supplier, but this is not what happens. There is a profit or loss on a hedge contract that takes place behind the scenes. This profit or loss in applied to a material price variance that results from exchange rate changes and offsets higher or lower part costs.

Forward contracts give you a fixed cost for your foreign currency and therefore for your foreign currency purchasing. If the interest rates in the foreign country are higher than they are in the US, the forward rate is at a discount to the spot rate, and this reduces the dollar cost still more.

Forward contracts also have the advantage of being suitable for internal transactions. If your company exports to the country you are buying in, and wants to sell in local currency, purchasing in local currency reduces the company's currency exposure. The purchasing flow of funds offsets the sales office flow of funds. If an internal forward agreement is made between the two departments, only the difference between the two flows needs to be hedged at banks.

Options allow a buyer to take advantage of an increase in the value of the US dollar but protect against a decrease. Unfortunately, they are expensive. A six month option on a volatile currency typically costs about 5% and most people choose not to buy them. An added difficulty is that option prices for the European style options that buyers need are not well listed in financial newspapers.

RISK OF BUYING IN DOLLARS
Dollars are not the safe course that many are led to believe. A dollar buyer starts off with a higher price than necessary. If the dollar weakens, he or she is paying even more. A more sophisticated competitor would be paying less. A supplier's competitors will soon let buyers know that they are paying too much. Other channels of distribution could also open up. Finally, promises of fixed dollar pricing are often broken when the dollar declines.

LENGTH OF HEDGING
Hedging for too long a period with forward contracts can lead to the same problems as buying in dollars. If the dollar increases in value, a buyer will be paying too much. Hedging for too long with options is expensive, because the option premium increases with time. Three months of orders plus three month lead time gives six months hedging, a typical period.

RISKS IN HEDGING
Hedging does involve some risks, but they are limited and can be controlled with simple attention to the fundamentals. Risk arises from forecast inaccuracy, and can lead to unexpected price variations, either up or down. If a company over forecasts purchases and hedges with forwards, there will be larger profit or loss on the hedge than the variance on part cost. With over forecasts, there will be a loss on forward contracts if the dollar strengthens and a gain if the dollar weakens. The total unexpected gain or loss will be approximately the percent over forecasted times the percent that the dollar changed. For example, a 20 % over forecast and a 15% currency strengthening will result in a 3% (15% of 20%) extra cost of the parts.

With under forecasts, some of the parts must be purchased at the spot rate without an offsetting hedge. If the dollar weakens, they will be more expensive and if it strengthens, they will be cheaper.

CHOOSING A HEDGING STRATEGY
The biggest gains in currency management will come from choosing the right currency. A good negotiator should be able to get an initial price reduction of 5% or more against a volatile currency like the yen or the mark. The next most consequential decision is whether or not to hedge. Not hedging opens the buyer to dollar price swings that are often 20% in six months. This uncertainty is unacceptable to most companies.

The third decision is to choose a hedging strategy. A recent article in the International Journal of Purchasing and Materials Management showed the benefits of actively choosing a hedge strategy based on a Bayesian statistical analysis of probable outcomes. Over a five year period, actively choosing a hedge strategy would have saved 3.6 percent compared to paying in the supplier's currency (yen) without hedging, and 1.8 percent compared to always hedging with forwards. The authors did not consider options as a potential hedge strategy.

If buying in the supplier's currency without hedging is unacceptably risky, and buying in dollars is excessively expensive, the choice is between hedging with forwards and hedging with options. If options were free, they would be the ideal choice, because they permit taking advantage of a stronger dollar and protect against a weaker dollar. However, options are not free, and almost always will be more expensive than forwards.

If you actively analyze probabilities of currency changes as the authors in the Journal recommend, and believe that the dollar will weaken, you should use forward contracts. They will give the same results as an option but at a lower cost. If you see no clear trend, make the choice based on relative costs. During two one-year periods when the dollar had no net change against the yen, options would have saved an average of 3.5% compared to forwards, before the costs of either. If the difference in costs between an option and a forward contract is less than 3.5% and you predict no increase or decrease, consider buying an option. If you predict a strengthening dollar, an option is the better choice. During a one year period of a strengthening dollar, options would have saved 7.71% compared to forward contracts. A Bayesian analysis with the correct probabilities would have predicted a 7.2% savings, and led to the correct choice.

SUMMARY
Choose the right currency based on the type of product and the location of the manufacturer. If you buy in foreign currency, most companies will find the risks of not hedging unacceptable. Have an escape clause whenever you price purchases in a foreign currency. Make an active effort to predict currency movements. Use a Bayesian analysis as the authors in the Journal suggest, but only compare the expected outcomes of forwards and options. Forwards will be the clear choice when you predict a weakening dollar. If you are predicting a flat or a strengthening dollar, options may be the right choice if they are not too expensive. The more strongly you predict a strengthening dollar, the more you can pay for an option. Be prepared to lead your company's finance staff into understanding the costs, risks, and benefits of foreign currency buying.

REFERENCES

Carter, Joseph R., Shawnee Vickery, and Michael P. D'Itri. "Currency Risk Management Strategies for Contracting with Japanese Suppliers." International Journal of Purchasing and Materials Management 29 (Summer 1993): 19-25

Min, Hokey and William Galle. "International Negotiation Strategies of U.S. Purchasing Professionals." International Journal of Purchasing and Materials Management 29 (Summer 1993): 46

Vickery, Shawnee, Joseph Carter, and Michael P. D'Itri. "A Bayesian approach to Managing Foreign Exchange in International Sourcing." International Journal of Purchasing and Materials Management 28 (Spring 1992): 15-20


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