Choosing Average or Quarter-End FX Rates for Royalty Payments
Summary
The discussion compares using an average exchange rate over the royalty earning period with using the rate at quarter end when royalties are paid in a different currency from product sales. It frames the choice first as a currency risk decision: fixing the conversion rate when royalties are earned can reduce exposure to exchange rate movements, especially when amounts can be estimated in advance.
If a company instead wants to compare the expected value of the two conventions without managing its currency risk, the answer points to interest rate differentials and forward pricing rather than inflation trends or historical exchange rate direction. A numerical EUR/USD illustration shows how an expected forward rate can differ from the expected monthly average. The discussion is brief and illustrative; it does not model actual royalty cash flows, quantify hedging costs, or establish a universally preferable convention. It notes that companies commonly convert once the amount is known.
Key ideas
- Choosing an exchange rate convention is first a decision about managing currency exposure.
- Fixing the rate when royalties are earned can reduce exposure if the amount is known or can be estimated.
- For an unhedged comparison of expected values, interest rate differentials matter more than historical exchange rate trends.
- The discussion uses forward pricing to explain why an end-period rate and an average rate may have different expected values.
Tags
Full text
# Is end of month fx rate or monthly average preferable for royalty contract # Is end of month fx rate or monthly average preferable for royalty contract 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? ## Answer by Lliane (score 1) https://quant.stackexchange.com/a/57676 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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