When K&E Tools orders supplies from Japan, owner Solvig Robertson crosses her fingers and hopes the dollar doesn`t fall against the yen before delivery date, when she has to pay.
When Sima Products Corp. orders parts from Japan, President Irwin Diamond doesn`t cross his fingers. He uses futures contracts to hedge against a change in the dollar-yen exchange rate.
”By no stretch of the imagination do I identify myself as a trader or as somebody who is even remotely sophisticated and sensitive to knowing how to deal in the marketplace of currencies or commodities,” Diamond said. ”I would no more get involved in commodities than fly. But you just can`t leave yourself exposed.”
K&E Tools and Sima Products are Chicago companies that import about $500,000 in goods annually from Japan. But only Diamond`s Sima Products has decided to hedge his currency risk.
Nationwide, however, Diamond`s conclusion seems to prevail. The world`s currency markets have mushroomed to more than $450 billion a day as businesses, financial institutions and speculators trade to protect against, or profit from, volatile exchange rates. Most of that market is in spot, or cash, trades. But an increasing number is in forward contracts arranged by banks or futures contracts traded on exchanges.
Forward contracts operate much like futures, in that they call for a certain amount of foreign currency to be delivered at a future date for an exchange rate set now. But unlike futures, forward contracts can be for any sum of money, can be in virtually any currency and can have any delivery date the customer wants. Futures are available only in certain currencies, have set delivery dates and are sold only in increments of 125,000 of the foreign currency.
At the Chicago Mercantile Exchange, where nearly all the world`s currency futures trade, currency futures contracts account for 30 to 35 percent of exchange volume, said Robert B. Gilmore, vice president of currency product marketing.
Currency futures began trading at the Merc in 1978, when daily average volume was only 6,309 contracts. Last year, daily average volume hit 79,979 contracts, and that was surpassed this year by August.
The growth of similar products elsewhere, particularly on foreign exchanges, will only stimulate existing markets, said David R. Ganis, president of Northern Futures Corp. Arbitragers, speculators or financial institutions with huge sums of money, can hedge one product against another to take advantage of even tiny spreads between returns, said Ganis, who also is president of the Futures Industry Association.
Gilmore said the increase in volume largely reflects the increase in companies that deal in more than one currency.
”If you have receivables in one currency and payables in another, you`re in a risk position,” Gilmore said. ”By doing nothing, you assume the risk, no different from a speculator who gets paid to assume risk.”
That`s not news to large multinational companies that consider fluctuating exchange rates just another business risk. But it sometimes comes as a shock to companies new to international business.
Robertson`s rude awakening came a little more than six years ago when her company, Railhead Corp., began its K&E Tools Division to import air-powered tools from Japan. She estimates that she imports $500,000 worth of tools a year, and her supplier demands to be paid in yen.
”When I started out, one of the first things I looked into was how many yen could I get for the dollar?” she said. ”At that time, it was about 280 yen to the dollar. I said, `What a great business to be in! I`m going to make so much money!` ”
Friday the yen closed at 136.27 to the dollar, meaning it takes more than twice as many dollars to buy a given amount of yen as it did when K&E began operations.
Adding to the problem, K&E sometimes has to wait up to six months for its orders to be delivered. If the dollar falls against the yen between the time the price is set and the time K&E pays, it will require more dollars to meet the agreed-upon price in yen.
For example, an order valued at 1.4 million yen would cost K&E $10,000 if the dollar were worth 140 yen. But if the yen falls to 134 to the dollar, it would take $10,447 to pay the bill. From the Japanese seller`s point of view, the price hasn`t changed, but from K&E`s standpoint, the order became more expensive.
”It`s killing me,” Robertson said. ”My cost has doubled in the past six years, but if I double the price of my tools, I will price myself right out of the market.”
In the last six years, K&E has raised its prices about 20 percent.
”That`s all I can do in order to be competitive,” Robertson said.
So the question becomes, how can a company eliminate or mitigate that risk?
Some multinational companies, such as American Express Travel Related Services, have their own currency trading operations. AmEx is billing and receiving payment in dozens of currencies, and it considers trading to be essential just to stay even, a company spokesman said.
Others don`t have in-house trading operations but tackle currency issues as a part of doing business. At Skokie-based Brunswick Corp., ”we do a forecast of what we believe the exchange rate will do,” said Frederick J. Florjancic Jr., vice president of finance. ”We subscribe to a lot of different economists` forecasting services, talk to our banks on a daily basis and obviously we have our own feelings from our own people who are physically located abroad.”
But Diamond said that step alone is beyond Sima Products Co., which designs and markets camera and video accessories. ”We`re a small company, and we don`t have economists,” he said.
Expertise aside, alternatives for companies such as Sima Products or K&E Tools are pretty much the same as for giants like AmEx or Brunswick. They can pay up front, thus losing interest on that money; arrange financing in the foreign country, using the foreign currency; or hedge to lock in the exchange rate at the date the deal is made. Hedging, through a bank or using currency futures and options, seems to be the most common solution.
Diamond said Sima Products never worried much about currency fluctuations until the company began buying parts from a Japanese company about a year ago. When faced with the volatile yen-dollar relationship, ”we called up a broker and got a yen futures contract,” he said.
That`s not practical for K&E, Robertson said.
”It would be nice to buy yen futures, but you have to have a lot of cash,” she said. ”Frankly, I just don`t have hundreds of thousands of dollars I can put into buying yen futures.”
Most executives probably would side with Robertson, not necessarily because of cost, but because of convenience.
”It`s unlikely that the corporation is going to go directly to the futures exchange,” said Northern Futures` Ganis. ”The corporations are going to go to a bank`s foreign exchange department and try to arrange a contract specifically tailored to their needs.”
The cost, too, is tailor-made, depending on the term of the contract, the currency involved and the bank`s view of the volatility of that currency. At the Merc, futures contracts in a given currency cost the same regardless of the buyer, though margin requirements and brokers` fees could vary customer to customer.
Even Brunswick, a Fortune 500 company, generally works through banks, Florjancic said, though the bank may not be in the United States.
Businesses generally are more comfortable dealing with banks than with futures exchanges, noted Ramon R. Uribarri, vice president of risk management products at Continental Illinois National Bank and Trust Co. of Chicago.
”A lot of corporate America is uncomfortable with these (exchange)
products,” he said. ”Forward contracts have been around a lot longer than the futures products. We can tailor-make a product to meet the customer`s profile.”
At the Chicago Mercantile Exchange, there are active markets in only the Japanese yen, deutschemark, pound sterling, Swiss franc, Australian dollar and Canadian dollar. Each contract is for 125,000 units of the foreign currency, and there are a limited number of delivery dates.
That flexibility appeals to Diamond, who said his company is switching to a bank that will write forward contracts. There often was a gap between the expiration of a futures contract and the date Sima Products needed the money, he said. That won`t be the case with a forward contract.
Continental and First National Bank of Chicago and the Merc also sell options, which are growing in popularity. Options operate much like insurance, in that the buyer pays a premium to offset a specific risk-in this case, the risk that the dollar will fall against another currency.
An option gives the buyer the right-but not the obligation-to buy a foreign currency at a future date for a set exchange rate. If, before the option expires, the dollar gains instead of loses strength, the company can ignore the option and buy the foreign currency on the spot market at the more favorable rate.
”We like to make the analysis of an option behaving like an insurance policy,” said Matthew Matthews, vice president of foreign exchange marketing at First National Bank of Chicago. ”If you buy a fire policy on your home, the best outcome is that you don`t have to use that insurance. But if your home does burn down, you exercise your option by collecting on your insurance. You pay a premium to be able to do that.
”To translate that to the options strategy, if disaster strikes and the dollar does go down, you call up the bank and exercise your option. If disaster doesn`t strike and the dollar goes up, that`s the best outcome. You can participate in that favorable move to an unlimited degree.”
But, like insurance, options aren`t free. Typically, they cost 3 to 5 percent of the total amount being hedged, Matthews said.
In a perfect world, a bank`s contracts and options for buying and selling currency would cancel each other out. Obviously that isn`t the case, so banks buy and sell those contracts among themselves in the multibillion-dollar interbank market. The biggest banks use not just the interbank market but futures and cash markets to hedge their overall risks.
Even with all these choices, there is a Catch-22 for small business. Banks generally aren`t interested in clients that need to hedge only occasionally or for small amounts-less than $100,000 for a forward contract or $1 million for an option.
”A smaller trader may just want to use the Chicago Mercantile Exchange,” Matthews said.
But learning futures strategy and coming up with cash to meet margin requirements isn`t nearly as easy as going to a bank, said Theodore W. Leban, vice president of foreign exchange at Continental.
Robertson feels trapped in that Catch-22. ”For somebody my size, there is nothing to do about it.”
