There are a number of general rules I would propose to those who need to enter into foreign exchange transactions or make international payments. I will use the example of US dollars to Euros but I believe they apply equally to other currency pairs. One observation I would make before entering into this discussion is that there is no such thing as the "perfect financial institution". Some will give good service in one area but be weak in others. The bank that served you well in your home town may be next to useless now that you are planning on moving to Italy. Don't get sentimental as you may end up paying for it dearly. Do your homework, read the fine print and weigh up the options â€?it is your money and you must take responsibility for it.
Choose a well-respected, large financial institution to do FX transactions:
You may have a long-standing banking relationship with a small regional bank, but the fact remains that the larger the institution, the more direct access to the foreign exchange markets they will have. I have nearly always used either a large retail bank or an international stockbroker. I once had some money with a relatively small bank in the UK and changed some USD to EUR and was shocked to see an exchange rate of about 5% worse than the market. It was only a small amount so it didn't really matter, but this is what can happen if you aren't careful. There is nothing to stop you opening an account with an international bank in Italy, making payments to that bank in US dollars and then getting them to change the funds to Euros, if this is more convenient. Don't be afraid to use more than one bank â€?just be sure that you know which one you are going to use for what. Make a trial transaction and check if the price they give you is a good one. You can see daily exchange rates on www.oanda.com. On this site they will give you a daily trading range so that you can check your bank's performance. Don't be afraid to complain if you don't think they have given you a good deal.
For regular, short trips, look at the option of a multi-currency account:
Many banks will offer the possibility of multi-currency accounts. These same banks will generally offer a Visa card that debits your currency account. This is an attractive arrangement, because you generally do not end up paying an ATM fee if you use a Visa card issued by a foreign bank. Unfortunately, you can still end up getting stung when moving funds between the various currencies that your account holds. Another advantage is that you avoid having to pay an international transfer fee as you never actually send funds out of your regular bank's home country. The drawback for someone living full time in Italy is that you will almost certainly need a domestic account to handle bill payments etcâ€? A combination of the two could, however, be an option.
For larger, one-off foreign exchange transactions, ask for a "shaded rate":
Terminology may differ from place to place, but generally you can ask for a better than quoted rate on any transaction that exceeds $100,000. Ask your bank and see what they say.
International payment fees:
You will end up paying some kind of payment fee when sending funds overseas. Typically this will be around $25. The bank that receives the payment in Italy may charge a fee for incoming funds from overseas, but this should not be more than â‚?.
It is almost impossible to predict exact movements of currency pairs (by this, I mean any combination of two currencies, for example US dollar against the Euro or Pounds Sterling against Japanese Yen etcâ€?, but it is possible to cover ourselves against future currency movements.
I'll try to illustrate the way one can achieve "cover" through a practical example:
Imagine that we shall receive $500,000 US from the sale of our house in the States in 3 months time after the transaction settles. We don't physically have the cash now, but we have a sale and purchase agreement so we can be confident that we shall receive the cash in three months. If we want to move to Italy straight after settlement and convert all the cash into Euros, we carry the risk of an unfavourable movement of the US dollar against the Euro in this three month period.
At this point, we can look to enter a currency forward transaction. What does this mean? We approach a financial intermediary and we say that we want a quotation for buying Euros at a specified future date (today + three months). Our intermediary will quote us a rate which will be based on the interest rate differential between the two currencies. This may seem strange, but it is really quite a simple mechanism. The way it works is that the intermediary will buy and hold the currency that we want to take delivery of in three months and the price we pay will be the interest rate differential.
Let's have a look at what difference it makes to our currency transfer:
If we had our $500,000 today, we could look to the rate quoted in the "spot" row: 1.2161. That means that our $500,000 are worth â‚?11,150 if we make the transfer today.
If, as in our hypothetical situation above, we can only deliver our dollars in three months time, the rate is going to be 1.2207, meaning that we get â‚?09,600.
This situation can be explained by the interest rate differential between the two currencies: The Fed Funds Rate is at present 3.25%, whilst the ECB rate is 2%. This extra 1.25% that the US dollars earn is the cost of knowing your exchange rate today. Obviously the bank wants to earn something out of the transaction, so a margin will be built in, but the rules are basically these.
The beauty of forward contracts are the fact that they give you certainty. It may cost you the interest rate differential, but the cost of finding the US dollar 20% weaker after three months would be far greater.
Another option to cover oneself against exchange rates is to buy currency futures. Currency futures work in much the same way as forward contracts, but they are standardised. The Euro FX contract traded on the Chicago Mercantile Exchange is worth â‚?25,000 and has expiries in March, June, September and December. There is also a mini future available which is worth half of the "big" contract (i.e. â‚?2,500). These contracts can be "rolled" at minimal cost (i.e. carried over from expiry to expiry) and are an effective way of protecting oneself against adverse movements in the exchange rate.
The above discussion of exchange rate risk gives an idea of how to cover oneself from adverse movements in the exchange rate. A necessary consequence of this is that you give away any possible gains that would arise if the exchange rate moved in your favour. You must have this clear in your mind before considering the above solutions and please do not be tempted to speculate because you will almost certainly lose!
About the Writer:
Andrew Lawford is a New Zealander who has lived in Italy on and off for nearly four years. He lives near Genoa, the largest city in the coastal region of Liguria and works for a SIM which is a member of the Italian Stock Exchange and offers brokerage services on the worlds main financial markets. He can be contacted at: firstname.lastname@example.org or by telephone on (+39) 3484 767576.