International trade involves a variety of risks which are rarely encountered in the pursuit of domestic commercial transactions. One of the key risks (or opportunities, depending on how effectively it is managed) is the exposure to foreign currency fluctuations and/or controls which are often inherent to transacting international business.

The cost impact arises because the importer must typically acquire (buy) US Dollars to fund the Letter of Credit, which is issued in US Dollars by the importer's Bank. If the value of the US Dollar increases or appreciates relative to the Canadian Dollar, it becomes more expensive to purchase the American currency using the Canadian Dollar, which makes the transaction more expensive for the importer, since everything ultimately gets translated back to Canadian currency.

On the revenue side, the French exporter, having agreed to transact business under a US Dollar Credit, will be paid in US currency, which must typically be sold (converted to the Euro). If the US Dollar appreciates against the Euro, the exporter earns a premium, being able to acquire more Euros for the US Dollar payment remitted under the Documentary Credit.   

Foreign Exchange Markets: A Brief History

Financial crises such as the Asian Flu, the devaluation of the Mexican Peso and the events in Argentina illustrate the importance of stability in International Financial Markets, including the Foreign Exchange Markets. 

The Bretton Woods agreement of 1944, aimed at stabilizing the global economy after the ravages of war, represented the first modern attempt to introduce some form of discipline to relative currency values, and articulated the foundation for a global financial system which, for better or worse, is still evolving today. 

Bretton Woods spawned both the World Bank and the International Monetary Fund (IMF), chartered to support post-war reconstruction efforts, and to oversee the management of the world financial system, respectively. The IMF was specifically mandated to make appropriate currency adjustments in order to create and maintain a sense of stability in global financial markets.

Currency values or exchange rates were originally set or "pegged" at certain values, and permitted to fluctuate only within tight bands around those values. Gold reserves were, for a time, the basis upon which exchange rates were determined, and the US Dollar was not only supported by American gold reserves, but officially exchangeable for gold.

The Gold Standard effectively collapsed in 1971 when the United States unilaterally withdrew its guarantee to exchange US Dollars for gold on demand. The US had accumulated a large Balance of Payments deficit, and was importing an ever-larger amount of goods and services from overseas, which resulted in accumulations of US currency in foreign countries, which the US gold reserves could no longer support.

The Current Model

In the aftermath of Bretton Woods, a Floating-Rate system of foreign exchange evolved, which is still in effect today, and is referred to as a "Managed Dirty Float". This expression refers to three characteristics of the system:

Special Drawing Rights 

Special Drawing Rights (or SDR's) are a financial instrument created by the IMF to act as another form of Reserve, intended to facilitate trade by creating liquidity in the marketplace. Participating countries in need can use SDR's to obtain currency from other participants designated by the IMF. Available reserves are allocated to member countries based on factors such as share of Gross World Product and  share of World Trade. The value of 1 SDR once represented the weighted average of five currencies - the US Dollar, the German Mark, the French Franc, the Japanese Yen and the British Pound.

Factors Impacting Exchange Rates

FX Exposure & Mitigation

Broadly stated, there are two categories of foreign currency exposure related to the conduct of business internationally. The first, referred to as Translation Risk, occurs when business transacted abroad in foreign currency (perhaps by a company subsidiary) must be reported and consolidated into the Parent Financial Statements, in domestic currency. The time lag between the foreign financial report and conversion/consolidation into the Parent statements creates the possibility that the foreign currency has devalued relative to the domestic, such that the revenues reported from the foreign business need to be revised downwards. Given the requirements of double-entry accounting that "Assets equal Liabilities plus Owner's Equity", decreases in the contribution of foreign operations will ultimately result in a decrease in Owner's Equity to keep the equation in balance. The Book Value of the company accordingly decreases. 

The second category of risk is referred to as Operating Exposure, where activities such as sourcing/purchasing in foreign markets can, in the event of unfavourable FX and/or price movements, adversely impact the Present Value of a company's (expected) cash flows, thus affecting not the Book Value, but the actual stock price, and by extension the Market Value.

A variety of financial devices exist to assist in optimizing or mitigating foreign currency risk exposure, the details and application of which can be assessed with professional assistance.

Foreign Exchange, as with many aspects of international commerce, presents risk as well as opportunity for the astute and well-informed business manager and executive. If your trade volumes are significant, or your deals are high value transactions, we recommend a thorough investigation of the impact of Foreign Exchange on your business, and a review of the opportunities which might exist to secure (or enhance) your success in the international market.