[caption id="attachment_79043" align="alignright" width="180"] VineNotes by Charles Day[/caption]

Foreign currency volatility can be a challenge for any California winery trading abroad. Whether importing barrels or bulk wine, the lack of certainty in U.S. dollar cost can adversely impact a winery’s bottom line.

As a result of sharp valuation undulations between the U.S. dollar and euro, California wineries have turned to foreign-exchange hedging products, such as forward contracts, to protect their profit margins.Paying it 'forward'

Wineries that buy or sell products into Europe or other foreign markets have many options when considering foreign-exchange (forex or FX) hedging. The most common hedging product utilized by California wineries is an "FX forward contract."

In general, an FX forward contract is an agreement to buy or sell a currency at a specific exchange rate and on a specific date -- or during a specific period of time. These contracts are obligations in which both parties deliver a specific currency to the other party, on an agreed-upon date and for an agreed-upon amount of another currency.

Wineries that know specifically when they will either receive or send a foreign currency will likely choose to enter into what is known as a "plain-vanilla" forward contract. This transaction requires that the winery either deliver U.S. dollars or the agreed-upon foreign currency to the institution providing the contract.

While this is typically a very straightforward transaction, issues may arise. Failure to deliver the agreed-upon currency on the specified date may require the financial institution to sell or "mark to market" the contract on the open market. This type of cancellation typically results in a financial gain or loss on the part of either party; depending upon the exchange rate differential between the trade execution date and the cancellation of the FX forward contract.

If a winery is not certain when it will either send or receive a foreign currency, it may find it advantageous to enter into a "window forward" contract. This allows a company to establish a date range when booking the forward contract. This is particularly valuable in situations involving the sale of wine in a foreign currency and not knowing specifically when foreign-denominated payment will be received.

Typically, a date range of up to 30 days is used under the forward contract. Given the lack of uncertainty surrounding the exact "value date" of the "window forward," exchange rates are generally slightly higher than exchange rates offered under plain-vanilla forward contracts.Hedging in restricted markets

Some countries, primarily emerging markets, have instituted currency restrictions that prevent their currencies from being freely traded in the foreign-exchange market. Wineries doing business with a counterparty domiciled in these markets will be restricted from using traditional FX forward contracts related to these restricted currencies. Within these markets, hedging is still possible using a nondeliverable forward contract (NDF).

In a NDF, the counterparts agree to an exchange rate at the time the transaction is executed and then settle a net difference between the agreed upon NDF exchange rate and the prevailing market spot rate at maturity. At maturity, the NDF rate will be compared to the current rate as set by the respective central bank -- typically a weighted average of the day’s rate.

If the foreign currency rate increased, the company entering into the nondeliverable forward will receive a payment in U.S. dollars institution providing the NDF contract for the difference between the NDF rate and the new exchange rate. If the foreign currency rate decreased, the company will make a payment. 

In addition to the NDF cash settlement, the underlying payment to the beneficiary for which the NDF contract was established would need to be made. Examples of currencies which have trading restrictions associated with them include the Chinese renminbi, Russian ruble, Brazilian real, Taiwanese dollar and Argentine Peso.Many options for FX hedging

These are only a few of the many options available to companies seeking to limit risk in foreign exchange. Because all FX hedging products involve some degree of risk, companies considering these instruments should have a comprehensive understanding of the benefits and limitations associated with each FX contract.

In addition, sweeping legislation such as Dodd-Frank has imposed significant limitations on the types of hedging products that financial institutions are permitted to offer to certain companies. Prior to entering into a FX hedging agreement of any kind, many financial institutions will impose certain criteria on their client, to ensure that they are a suitable counterparty for FX hedging contracts....

Charles Day is regional agribusiness manager for Rabobank, NA, serves the financial needs of the wine industry in Napa and Sonoma counties and elsewhere on the North Coast. Contact Mr. Day at 707-545-6887 or Charles.Day@rabobank.com.