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Should a corporation that receives quarterly royalty income, on products sold in different currencies than the one in which royalties are paid, specify the relevant fx rate as the quarterly average or end of quarter rate? Intuitively the monthly average rate has a lower variance so it should be preferred. Am I missing any nuances here?

edit: I just had the following thought. Wouldn't it make sense to look at historic trends of the exchange rates?. If the currency we are getting paid in has higher inflation rates than our key markets we would want to use the end of quarter rates. Does that make sense?

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  • $\begingroup$ I would put it a bit differently. Ideally the user would pay the company a small sum every time they make a sale of the product (or benefit from the product), which would be converted at the extant FX rate. So using an average FX rate makes sense when the payment is actually made in one lump sum at the end of a period. It tracks the economic value of the product better. $\endgroup$ – noob2 Aug 26 at 16:36
  • $\begingroup$ Just to clarify, I am not interested in what contract makes sense from an economic point of view for both parties, but which one is better for the party receiving the royalties, assuming that they can choose between the two. $\endgroup$ – robot112 Aug 26 at 17:22
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There is two ways to see it:

  • The first one is as noob2 mentionned, do you want to reduce your currency risk exposure? In that case, the rate should be fixed when the royalties are earned (presumably through the month, but typically even before if the amounts can be estimated).
  • The second one is if a very theoretical case where you don't care about your currency risk exposure, but simply want arbitrage between the two methods (I don't see why you would want to do that but anyways..). In that case, your arbitrage is not based on inflation rates or historic trends but on interest rates. You should opt to receive at month end if the foreign currency has a lower interest rate than your local currency, because the expected value you will receive will be higher than taking an average. For instance if your foreign currency (royalties earned) is EUR and your local currency USD (royalties paid), the spot rate is 1.1869 and the 1 month rate is 1.1876, choosing the average rate over the month would give you in average roughly 1.1873 (expected value of 1 month average converging to the forward rate), while choosing month end would give you an expected value of 1.1876.

Needless to say, normal companies will opt for converting to local currency as soon as the amount is known.

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  • $\begingroup$ "Needless to say, normal companies will opt for converting to local currency as soon as the amount is known". I think you may have not fully understood the question. We receive quarterly royalties on the sales that other companies make. The amounts paid to us are in our currency so we do not undertake any currency conversion ourselves. $\endgroup$ – robot112 Aug 28 at 9:57
  • $\begingroup$ You said you controlled the timing of the conversion, so it's the same thing as doing the conversion, the earlier the better to limit fx risk. $\endgroup$ – Lliane Aug 29 at 5:43
  • $\begingroup$ There still seems to be some confusion. Here is an example: We receive 10% of a products net sales in Turkey at the end of each quarter . We receive this amount in GBP. Now the question is at which exchange rate they should calculate the amount owed to us in GBP. Clearly (this is not at all theoretical) we would prefer them to use the beginning of quarter rate as there is a clear trend of the Lira depreciating against the Pound (as can also be seen by the forward rates) $\endgroup$ – robot112 Aug 29 at 6:26
  • $\begingroup$ Yes, this is not a contradiction with what I stated. In that case the two factors are aligned (hedge the exposure as soon as possible and better spot rate than forward rate). $\endgroup$ – Lliane Aug 30 at 4:23

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