Share and share alike.

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 subsidiaries.

Nevertheless, sensitive agreements are appropriate in many situations, such as in markets that are highly price competitive. In these cases, relatively small exchange rate fluctuations of 1 percent to 2 percent might produce a significant competitive advantage. You'll have to decide whether the tradeoff in hedging your currency exposure is worth the extra costs.

If you decide against it, note that sharing moves outside a range lets you reduce only the exposure of large exchange moves. That's useful if the operational cost of price adjustments for small moves is too high.

MAKE IT A PERFECT MATCH

Sharing agreements based on an average work well when product shipments and cash flows between you and the other company occur regularly. Suppose you supply a just-in-time manufacturer in Japan. You ship the product and invoice for it daily. Therefore, a sharing agreement that adjusts the exposure based on the daily average will match your currency exposure.

The most important step in evaluating a sharing agreement is determining the cash flow as a function of the exchange rate. To do this, it's helpful to test the sharing formula for a wide range of exchange rates and graph the result. This allows you to see exactly where your exposures are.

Which currency should you price the product in before adjusting for exchange rate movements? The currency of the product (or contract) price is important in determining whether the price will increase or decrease after an exchange rate move. For example, compare two possible agreements for a U.S. company - one to purchase products from Japan at a contract price of 1,000 yen, and a second to purchase products at a contract price of $9.43 (implying a spot rate of 106 yen to the dollar). The Japanese company and the American company agree to share exchange rate gains and losses, with a fifty-fifty split.

When the spot rate moves up to 108 or 109, the yen weakens against the dollar, and when the rate moves down, the yen strengthens. The currency of the product price will determine if the price adjustment is an increase or decrease as the dollar strengthens. A stronger dollar creates price decreases in an agreement with dollar prices and price increases in an agreement with yen prices.

To envision this, imagine the exposure to the U.S. company without the sharing agreement. If the dollar strengthens and the contract price is fixed in yen, the U.S. company experiences a currency gain. Purchasing the product requires less than $9.43 under a sharing agreement. If the companies have a sharing agreement, the U.S. firm should also see a gain when the dollar strengthens, but it will share the gain with the Japanese vendor.

Note that in both cases, the effective dollar price decreases! In the first case, this happens because the actual dollar price decreases, while in the second case, the dollar value of the increased yen price is less than the contract price of $9.43.

The formula used to adjust the price is one example of the many options you have in structuring a sharing agreement. It's a good idea to note the exact adjustment formula, because this will determine important parameters for the hedge. In the previous example, you'd use the formula to calculate what the gain would have been without a sharing agreement, divide this gain or loss in half and add or subtract it to the piece price converting at the current spot rate.

How do you determine the appropriate exchange rate band? The parties involved typically negotiate the center and the width of the exchange rate band, and here several issues arise. The first is the forward-rate differential (the difference between the spot rate and the forward rate). To have equal valuation, a sharing agreement must be strategically centered around the appropriate forward rate, not the current spot. If the forward rate is near one of the band limits, the sharing agreement may end up being very lopsided. (Of course, sometimes that's intentional. Often one party will opt to let the sharing agreement favor the other as a selling point to close the deal.)

JUMP ON THE BANDWAGON 

In selecting the right band, you should examine both the market approach and the internal approach. With the market approach, you let forward exchange rates and your observations on currency volatility guide your choices. The internal approach, on the other hand, focuses more on the financial and hedging impacts of various ranges. In other words, the range of the agreement should produce an exposure that meets your strategic objectives.

How does market volatility figure into your negotiations? You can use the current volatility of the exchange rate and other market conditions to determine the likelihood of hitting the band. If you're very likely to hit the band and the operational cost of adjusting prices is high, you and the other party may want to increase the band width. You may also want to widen the band if your company is looking for disaster insurance against large exchange rate moves. In this case, the band should be wide so that you and the other party rarely invoke the sharing agreement. On the other hand, if you want an agreement sensitive to currency moves, which would be the case if small exchange rate moves produced a price advantage for your company, the band should be narrow.

What exchange rate does the contract imply? Suppose a German manufacturer sells its product for 150 deutsche marks in Germany. The manufacturer has just signed a contract with an Italian company to sell the product. The contract will specify a piece price in Italian lira. If the spot rate is 1,082 lira per deutsche mark and the one-year forward rate is 1,150, the companies should decide what rate they'll use initially to set the contract price of the product - the spot, the forward or an average of forward rates. They also must decide whether to use this implied exchange rate to center their sharing agreement within a range.

How will you calculate foreign exchange gains and losses? Once you've determined the exchange rate is outside the band and you need to share foreign exchange gains or losses, you must calculate the size of the gain. Whether you measure from the center or the end points of the range, the sharing agreement is invoked only if the exchange rate is outside the band.

Which currency will you and the other party denominate your invoices in, and in which currency will you make payments? The sharing agreement may not cover the exchange rate moves that occur between the invoice date and the payment date, so any lags between the price adjustment and currency payment can introduce a currency exposure in addition to the exposure of the sharing agreement, in effect creating a different hedging strategy after the invoice date than before.

At what point does the price adjustment affect the goods you ship? Let's say you're a manufacturer who ships goods to your customer evenly throughout the month. At the end of each month, you send an invoice for the goods shipped during that month. If the exchange rate average over the month is outside your predetermined range, you simply adjust the invoice accordingly.

Or you can adjust the price of goods you'll ship in the future, depending on how often you ship. In this case, you'd change the price of the goods you're planning to send the next month. The following month's invoice would reflect the price adjustment.

Other than exchange rate movements, what circumstances or conditions, if any, will occasion a price adjustment? To hedge the exposure properly, it's important to know the precise size and scope, because any variations - for example, price adjustments because of movements in raw material prices - will affect the hedging strategy.

When and how will you renegotiate the sharing agreement? An agreement that isn't re-evaluated for a long time may contain off-market rates. Depending on the nature of the agreement, this may be perpetually unfavorable for one party, and it may be prohibitively expensive to hedge off-market exchange rates. Therefore, sharing agreements that let you periodically renegotiate, or renegotiate when significant exchange rate moves occur, will give you the most flexibility in hedging.

Where and when do you get the exchange rate or exchange rate formula you'll use to determine the occurrence and magnitude of a price adjustment? Most currency transactions occur over the counter in the interbank market, so you might need to call a bank to get the current rate. The reference rates for sharing agreements are often published, such as those in the Wall Street Journal, or you can use central bank fixing rates, such as the Federal Reserve or Bundesbank fixing rates. You can also formulate an average rate from several different rates.

HEDGING YOUR BETS

As you know, the right hedging strategy for your company depends on the exposure, risk reduction, upside potential, market conditions and cost. But some basic issues in identifying, measuring and hedging the currency exposure a sharing agreement creates are intrinsic to all firms.

For example, an American firm and a Japanese firm want to hedge their downside exposure but participate in any upside. They could accomplish this by purchasing a yen call/dollar put with a strike rate at the center of the range. The size of the option is half the exposure without the sharing agreement. Both firms would purchase the same option, the yen call, and both experience currency losses when the yen appreciates.

To illustrate, suppose the American company, National Manufacturing, will purchase a tractor from Shimoto, the Japanese manufacturer [ILLUSTRATION FOR CHART OMITTED]. The contract price is 10.6 million yen. The two firms agree to share equally all currency gains or losses only if the exchange rate finishes beyond a specified band.

National is exposed to currency movements on the full 10.6 million yen in the range (100.70 to 111.30) without a price adjustment. To protect its downside exposure in this range, it needs to purchase a yen call struck at 106, the center of the agreement. At a rate of 106, the expense to purchase the tractor is $100,000, the value budgeted by National Manufacturing. This option is particularly expensive because it is more than 3.5 percent in the money forward!

The current forward rate is 102.17, the current spot is 105.50 and the option is the right to buy yen at 106. For ending exchange rates below 100.70, both companies share the exposure equally. Because National doesn't need to hedge the full 10.6 million yen against ending rates below 100.70, it can reduce its net option premium by writing a 100.70 yen call on 5.3 million yen.

Shimoto is exposed only to ending exchange rates outside the band. Within the range, the price is fixed in yen, resulting in no exposure to Shimoto. To protect its downside, Shimoto can purchase a yen call struck at 100.70 on 5.3 million yen.

Why does National pay more than Shimoto to hedge its position? For ending rates below 106, National will always incur a greater currency loss than Shimoto. For example, let's examine what would happen if the ending exchange rate were 88.00. Using a sharing formula, the price decrease would be 668,421 yen for a net price of 10.6 million yen minus 668,421 yen, which equals 9,931,579 yen. At a conversion rate of 88.00, 668,421 yen equals $7,596.

The dollar cost of the tractor would be 9,931,579 yen divided by 88.00, which equals $112,859. That's $12,859 more than the budgeted expense. National experiences a larger currency loss at 88.00. This occurs because the agreement provides for equal sharing outside the band but not within it. Within the band, National carries the currency risk. It can divide its total currency loss into two components. The first is $5,263, which is the loss from the implied rate of 106.00 to the lower edge of the band rate of 100.70. National doesn't share this portion with Shimoto.

The second portion is $7,596, which is the loss from the lower band rate of 100.70 to the ending rate of 88.00. This is the portion National shares with Shimoto via the sharing agreement. The magnitude of the exposure outside the band is unlimited, but the downside exposure inside the band is capped at $5,263, the difference between 106.00 and 100.70.

As this example demonstrates, you have plenty of options in structuring a sharing agreement. Just make sure you periodically review and update the parameters of the agreement so it continues to meet your requirements. That'll give you one less risk management headache to worry about.

Mr. Godfrey is a vice president and foreign exchange risk analyst at Bank of America in San Francisco. He can be reached at [phone].