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Currency Clauses



Currency Clauses

 

A good way to deal with currency risk can be to include a currency clause in the sales contract, which address problems that might result from fluctuations.

Indeed, by doing so the selling price could be amended if an adverse currency fluctuation occurs.

Freezing clause

Here the contract price is based on a fixed exchange rate meaning that if an adverse fluctuation occurs, the beneficiary of this clause can ask the other party to bear the associated costs.

Let’s take the example of a French exporter who has concluded a 10 000 000 JPY deal with a Japanese Importer of at fixed exchange rate of 1 EUR = 119 JPY. In this case, the translated amount should be 10 000 000 JPY * (1/119)= 84 033 EUR

If the exchange rate becomes 1EUR= 130 JPY then the impact on the translated amount could be 10 000 000 JPY (1/130) = 76 923 EUR

Alternatively if the exchange rate becomes 1EUR=105 JPY then the impact on the translated amount could be 10 000 000 JPY (1/105) = 95238 EUR

However in this case, since a Freezing clause has be included in the contract, the price paid to the French exporter will remain 84 033 EUR and any variation will be borne by the buyer who will have to apply the initial exchange rate as agreed in the contract.

In short, with a freezing clause the Exporter can avoid the risks resulting from the depreciation of the foreign currency that can potentially harm his profit margin.

Note that the Importer could also benefit from using this clause when the payment has to be made in a foreign currency.


Price adjustment clause

A) Proportional price adjustment

This clause enables the contract price to be adjusted to the exchange rate.

Let’s take the example of an Irish exporter who has concluded deal with an American Importer where a proportional price adjustment clause has been included in the sales contract. It has been agreed that a payment of 300 000 USD (or 280 740 EUR) will be made at a given date, at a fixed exchange rate of 1USD=0.9358 EUR

Therefore if the exchange rate becomes 1USD=0.9000 EUR the exporter is entitled to claim for a price adjustment. The price will be adjusted to 311 933,33 USD (300 000*0.9358/0.90) or 280 740 EUR (311 933,33 / 0.9358).

In much the same way, if the exchange becomes 1USD = 0.9839 EUR the price paid by the Importer will become 285 333.87 USD (300 000*0.9358/ 0.9839) or 280 740 EUR (285 333.87 / 0.9839)

In both cases the amount translated in Euro will remain unaffected by those fluctuations of the EUR/USD parity, since the prices have been adjusted proportionally.

Note that the Importer could also benefit from using this clause when the payment has to be made in a foreign currency.

B) Adjustment within a tunnel price

In this case the clause determine an upward and downward limit (+/- 5% for instance) beyond which the price will be adjusted.

Let’s take the example of an Italian exporter who has a 10 000 000 INR (or 140 449 EUR) deal with an Indian Importer at a rate of 1 EUR = 71.2002 INR with a fluctuation band of +/- 5 %.

This gives us the following threshold limits:

Upward limit: 1EUR= 74,76021 (71.2002 + 5%)

Downward limit: 1 EUR = 67.64019 (71.2002 – 5 %)

In other words as long as the EUR/INR exchange rate fluctuates between 74,76021 and 67.64019 Indian Rupees for 1 euro, the price will remain unchanged.

However beyond this fluctuation range a price revision will take place (upward or downward).

Please note that the clause must state clearly whether the price revision should be calculated based on the initial price or from the predefined threshold.

Put differently, if the threshold is +/- 5 % and the currency rate reaches 10% fluctuation, should the price reflects the 10% change or just the difference from the agreed threshold, which is 5% (10%-5%).

In short, it is important to make sure that the modalities of the price revision are precisely specified.


Currency risk sharing provision

 

This clause enables to share equally the impact of currency fluctuations between the Importer and the Exporter, from the signature of the sales contract to the transaction settlement (payment).

Let’s suppose that a given French company exports a container of goods to an American Importer for a total amount of 10 000 000 USD (or 9 394 000 EUR) with an exchange rate of 1 USD= 0.9394 EUR.

Since the sales contract included a clause, which indicates that, the currency risks will be shared equally, the following will unfold:

Billing currency appreciation scenario

 

If the exchange rate becomes 1 USD = 1.05 EUR

The difference between the initial rate and the last rate will be 0.1106 (1.05-0.9394).

Since this difference will be evenly shared, the new rate that will be applied to the contract is 1 USD =0.9947 USD (0.9394 + (0.1106 /2))

Therefore the new price paid by the Importer 10 000 000 * 0.9394 /0.9947 = 9 444 053 USD.

Conversely, the French company will receive 9 916 255 EUR (9 444 053 * 1.05) instead of 10 500 000 EUR (10 000 000/1.05) if this clause would not have been included in the contract.

Billing currency depreciation scenario

If the exchange rate becomes 1 USD = 0.85 EUR

The difference between the initial rate and the last rate will be 0.0894 (0.9394 – 0.85)

Since this difference will be evenly shared, the new rate that will be applied to the contract is 1 USD= 0,8947 EUR (0.9394 – (0.0894 /2))

Therefore the new price paid by the US Importer will become 10 499 608 USD (10 000 000 * 0.9394 / 0,8947)

Conversely, the French company will receive 8 924 666 EUR (10 499 608 *0,85) instead of 8 500 000 EUR (10 000 000 * 0.85) if this clause would not have been included in the contract.

As we can see with this clause, when the billing currency appreciates (first case), both the Importer and the Exporter are better off. In much the same way, when the billing currency depreciates both the Importer and the Exporter bear the costs of this depreciation.


Currency option provision

This clause allows to determine multiple currencies within which the payment will be made. The idea is that if the main currency within which the contract is denominated fluctuates beyond a certain level, the buyer could switch to another currency providing that it has been specified in the agreement.

Let’s take the example of a Spanish importer who has a 500 000 USD deal (or 480 000 EUR) with a US company at fixed rate of 1 USD = 0.96 with an option to switch the payment to the British pound (GBP) if the USD experience an appreciation of more than 5 %.

In this case, as soon as the USD reaches 1USD = 1.008 EUR (0.96+ 5%), the buyer will be entitled to pay in GBP.

Therefore if the spot rate at the time of the payment is 1GBP=1.18 EUR then the buyer will pay 406 779.661 GBP (480000/1.18) instead of 504 000 EUR (500 000*1.008).


Warning

When currency clause in included in a sales contract, it is of paramount importance to be as specific as possible by determining:

When should the price adjustment take place?

Beyond a given exchange rate, beyond a given threshold, etc…

How should the adjustment be implemented?

Automatically or upon agreement between the parties

Tunnel price adjustment modalities.

 

If the threshold is +/- 5 % and the currency rate reaches 10% fluctuation, should the price reflects the 10% change or just the difference from the agreed threshold, which is 5% (10%-5%).

 

The type of currency exchange rate that will be used as a reference

 

Since a comparison between the initial and the new rate is needed, the clause must determine the type of exchange rate that will be used in order to avoid potential conflicts. Put differently it must decided whether the buying rate, selling rate or mid rate will used as reference.

The source of this rate: a central bank, a given commercial bank

 

Please click on the links below for more hedging techniques