The recent devaluation of the Chinese Yuan by China’s central bank, the currency’s largest one-day loss against the US dollar in two decades, has disrupted commercial and financial arrangements entered into on the assumption that the currency would remain closely pegged to the US dollar. This unexpected exchange rate shift, along with regular fluctuations in the value of other global currencies, highlights the need to manage how exchange-rate risk is allocated and managed in commercial agreements.
The most basic mechanism for allocating currency risk (present in most commercial agreements) is to specify the currency with which payment must be made. Without any other mechanisms in place, specifying the payment currency will generally allocate the risk of currency appreciation to a customer to the extent that the customer must purchase the stated currency to make payments, with the risk of currency depreciation borne by the supplier to the extent that depreciation is against the currencies in which the supplier incurs its costs or states its financial results. When parties are unable to satisfactorily manage their own currency risks, or when exchange-rate fluctuations could lead to significant inequities in commercial agreements, contracting parties should consider a number of potential mechanisms to mitigate those risks, including the following:
- Price Adjustments. The agreement may provide for price adjustments to account for exchange-rate fluctuations. The price adjustment mechanisms may be automatic and indexed to spot rates or average exchange rates for a set period. Alternatively, changes in exchange rates of a particular magnitude or outside of a fixed range may trigger renegotiation of prices.
- Reserves or Surcharges. The pricing terms under the agreement may include a surcharge or reserve as a cushion for suppliers to account for exchange-rate fluctuations. This may be a simpler mechanism for contracting parties to administer, but depending on the relative volatility of the currencies in question, it may over- or under-compensate one of the parties. The mechanism may also provide for periodic adjustment of the surcharge or reserve to account for longer-term changes to exchange rates.
- Set Exchange Rates and Reconciliations. The agreement may provide for a fixed exchange rate or exchange rates. To account for differences between the set rates and actual rates over time, fixed exchange rates are often accompanied by a periodic reconciliation with the actual published rate at the time that goods or services were provided or invoiced or with the average exchange rate over some set period. Reconciliation payments to account for the total difference between the fixed and actual rates are often invoiced only when the amounts exceed a certain percentage of total fees or other threshold.
- Termination Rights. The agreement may provide for termination rights in the event that extreme exchange-rate fluctuations render the agreement commercially unfeasible for one or both parties.