Share and share alike.

• Author: Godfrey, Stephen
• Position: Managing foreign currency exposures

Do foreign currency exposures make you feel a bit queasy? Banish the butterflies with a sharing agreement, which can help you and your overseas customers ride out currency fluctuations.

You're the CFO of Widgets Co., an American firm that's planning to sign a long-term contract to sell a component to Gizmo, a manufacturer in Germany. It's your first venture into overseas markets, and your operations people are a bit concerned about the currency exposure. If you price the product in deutsche marks, your company will be exposed to fluctuations in the U.S. dollar/deutsche mark exchange rate. The dollar value of your German revenue will fluctuate as the exchange rate moves. Since Gizmo is deutsche-mark-based, it won't have any currency exposure if you price in deutsche marks. The entire exposure resides with your company.

But if you price the component in U.S. dollars, you'll run into the reverse situation: Gizmo will be exposed to currency fluctuations. Assuming neither one of you wants the currency exposure, one solution is to share the exposure under a currency sharing agreement, a way to divide foreign currency risk between two counterparties.

To properly manage your risks, your company and Gizmo need to answer two questions: What are the currency gains or losses and when do they occur? Consider what happens when you don't have a sharing agreement. If you price in deutsche marks, you will, of course, have an exchange rate loss when the deutsche mark weakens against the dollar and an exchange rate gain when the deutsche mark strengthens. If you price in dollars, Gizmo will experience an exchange loss when the deutsche mark weakens.

A sharing agreement will identify, divide and allocate these losses to each counterparty. The agreement itself is a simple contract. It's working out what your currency exposures are and what rate you want to use to measure exchange gains and losses that pose the difficulties. If you're interested in setting up a sharing agreement between your company and another, here are some questions to help guide your negotiations.

What are the terms of the agreement? Clearly, the number of sharing possibilities is limitless. You can set up a fifty-fifty split (or any other ratio) on all foreign exchange gains or losses. Or you can condition the agreement on whether or not the rate moves beyond a specified range. Some companies arrange to share all foreign exchange gains and losses only if the average rate changes by more than a certain amount, while others share all foreign exchange moves outside the range. Still another possibility is repricing the product if the exchange rate has shifted by more than an agreed-upon level.

If you decide to share all your exchange rate moves, realize this type of agreement implies that all moves, large or small, are important to both counterparties. This can be operationally difficult to implement because you'll have to constantly adjust your prices. The costs of doing that can include monitoring the exchange rate to determine if and when a price adjustment is necessary and advising the counterparty of changes. You'd have to do that under any kind of sharing agreement, but in this case you'll have to do it more frequently. You'll also have to implement the change in your company's information systems, such as purchasing, invoicing and accounting, and throughout your network of vendors and...