The Pricing Edge: Why FX Forwards Make the Difference

In my previous post, I discussed how negotiating in local currencies can give a tour operator a competitive pricing edge. In short, by making offers using the local working currency, tour operators can gain better prices through cutting out the ‘middle-man’ (aka the banks) and save, on average, 2.5%. The savings can be applied either to boost profit margins or by giving the pricing department more leeway in their discount strategy.

That being said, managing locally-negotiated prices requires astute follow up from the CFO. They must now not only deal with working with currencies on a daily basis, but also avoid exposing the company’s balance sheet to FX risk. For most tour operators, this is easier said than done.

The Currency Headache

By negotiating in the local currency, tour operators give their companies considerable competitive advantage. However, once the price is locked in by the product manager, the CFO and treasury must protect themselves from FX exposure risks.

Like practically any other traded commodity, currency markets are generally free to float. The movement between currency pairs is driven by a large range of factors - be it monetary and fiscal policy changes, political fallout, or even pure speculation. As such, no one company has the ability to fully control the market (although a few major banks have certainly tried).

For the tour operator, negotiating in a foreign currency means that there is an additional element in their accounts Receivable (AR) and Accounts Payable (AP) ledgers. Primarily,, this means collecting cash in one currency and paying it out in another. Let’s take an example.

A tour operator based in Germany built a 10-day all-inclusive package to Koh Samui in Thailand for winter/spring 2017. They negotiated with the resort in Thai Baht (THB) and are selling the package in Germany in EUR. At one point, during the sales cycle, the tour operator will have to convert their EUR into THB to pay their provider. How and when they do this will define the success or failure of their negotiating strategy.

Forwards: FX’s Paracetamol

For any person, this process is complicated in its own right. When that person is managing multiple currencies and hundreds if not thousands of sales a week, it’s no surprise that CFOs develop massive FX-related headaches. Luckily, there’s a cure.

The CFO and, by extension, the treasurer have three options to manage their FX requirements:

• Wait until the day the payment is due to do the FX transaction
• Constantly buy the AP currency each day, holding it on a bank account, then transferring the money on payment date
• Buying a forward contract at time of sale, locking the rate, due on payment date.

For the first option, the tour operator is effectively negating any advantage of negotiating in local prices. Since they will only convert the currency on the due date, they are at the whims of the market. If the currency pairs move against them, they lose money.

To avoid playing roulette on payment date, the treasury could buy the currency daily. However, this also means that they are buying the amount in full. In order to do so, the tour operator must have the cash-on-hand to execute the exchange. This method isn’t optimal. It reduces liquidity and increases manual workload on the treasury. Additionally, if there is an issue with the inbound cash flows, then the trade will fail; further complicating the finance department’s day.

Instead, the treasury should buy a forward contract each day to lock in their exchange rate. The logic is quite simple: during negotiations, the tour operator and provider agreed upon a payment schedule. Each time that the tour operator records a sale, they buy a forward contract with maturity on the next payment date, effectively mitigating future FX exposure risks..

In turn, this strategy gives the CFO options that were previously unavailable. For one, the company can take an additional profit when the currency pair moves in their favour. More interestingly for tour operators in hyper-competitive markets (which, for the travel industry, is usually the case) is the new-found pricing flexibility.

As the currency pair moves in the company’s favour, the CFO can choose to discount prices at a rate parallel to the movement. So if the exchange rate moves up by 2%, then the tour operator can offer a corresponding 2% discount all while maintaining the desired profit margins.

Furthermore, forwards only require that the buyer deposit a margin at purchase. The final amount is only due at the maturity of the contract. This gives the treasury added liquidity and allows them to accurately forecast cash needs well in advance.

Keep the Headache from Coming Back

In practice, it isn’t quite this easy. The treasury still has to calculate each day’s expected inbound cash flows, when the corresponding accounts payable is due, instruct and monitor their forwards. This in itself requires dedicated treasury resources. That being said, there are customisable solutions for tour operators wishing to automate the heavy lifting associated with complex FX policies.

In any case, serious tour operators, whether they like it or not, must deal with FX portfolios. The challenge can be daunting. However, in the cut-throat tourism industry, doing so is a matter of survival. My guess is that the market leaders in the travel industry mastered their currency strategies long ago.

Interested in learning how your company can benefit from forwards? Click here to get a free analysis from one of our FX experts!