Letters of credit and FX: the two risks you think are covered and are not
A confirmed letter of credit secures the payment. It secures neither the conversion rate nor the collection date — and it is precisely that pair that makes hedging a documentary transaction delicate.
A letter of credit is an excellent instrument for securing payment. It is regularly presented internally as « the transaction is secured », a phrase that covers two costly silences.
First silence: the currency
A letter of credit guarantees payment of an amount in the stipulated currency. If the contract is denominated in dollars, the bank's undertaking is in dollars. The risk of converting into euros is entirely yours, exactly as on an ordinary invoice.
The guarantee covers being paid, not what the payment will be worth in euros. A perfectly executed letter of credit on a USD 2 million transaction can end up EUR 90,000 short of plan if the euro has appreciated 4.5 % between signature and collection.
Second silence: the date
This is the point that genuinely complicates hedging. Payment under a letter of credit does not fall on a fixed date but on presentation of compliant documents. And compliance at first presentation is far from the rule: a significant share of presentations contains at least one discrepancy, and each discrepancy triggers a documentary round trip of several days, sometimes several weeks.
A forward hedge, by contrast, has a fixed date. The gap between the two creates a concrete problem:
| Scenario | What happens | Consequence |
|---|---|---|
| Collection on the expected date | The hedge unwinds normally | None |
| Collection three weeks late | The hedge matures with no currency to deliver | The hedge has to be rolled — a roll that is quoted and paid for |
| Collection early | The currency arrives before the hedge matures | It sits in the account, exposed, until maturity — or the hedge is brought forward, which is also quoted |
The three possible answers
- 1Hedge with a date buffer
Set the hedge's maturity after the theoretical payment date, allowing a realistic documentary processing period. This is the simplest and most widely used solution.
- 2Use a forward with an optional delivery date
Some forward contracts allow delivery within a window of several weeks rather than on a single date. The guaranteed rate is slightly less favourable — the bank protects itself against the uncertainty — but the date problem disappears.
- 3Hedge at actual collection
Hedge nothing until the funds arrive, then convert. This means giving up the hedge: over a documentary cycle of several months, the exposure is carried in full throughout.
The detail that changes everything: the hedging date
The operational question is: from when should a transaction under a letter of credit be hedged? The answer is not the issuance of the credit, it is the signature of the commercial contract. That is the moment the price is committed, and therefore the moment the exposure arises. Waiting for the letter of credit to be opened — often several weeks later — leaves an unhedged exposure over the most uncertain period of the transaction.
What to ask your bank
- The cost of rolling a hedge, in advance, so you can weigh a date buffer against a possible roll.
- The availability and extra cost of a forward with a delivery window on the pair and horizon concerned.
- The average observed delay between presentation of documents and actual payment for the country and issuing bank concerned — information documentary departments hold and rarely volunteer.
Calculate the cost of a window hedge
The pricer gives the forward rate for each maturity: enough to quantify the gap between a fixed date and a documentary safety buffer.
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Frequently asked questions
The questions finance departments ask most often on this topic
Should FX be hedged as soon as the letter of credit is opened?
Earlier than that: from the signature of the commercial contract, the moment the price is committed and the exposure arises. Between signature and the actual opening of the credit, several weeks often pass during which the exposure is real but unhedged.
What if the documents are rejected and payment is delayed?
The hedge has to be rolled to the new estimated date. That roll is quoted at the market rate on the day of the roll and can be favourable or unfavourable depending on the direction of the interest rate differential between the two currencies. Anticipating that cost, by asking your bank beforehand rather than when the problem arises, avoids a decision taken under pressure.
Does a confirmed letter of credit remove all risks?
It removes the buyer's non-payment risk, the risk on the issuing bank and country risk. It removes neither FX risk nor documentary risk — that is, your own ability to present strictly compliant documents within the deadlines, which remains the leading cause of difficulty in practice.
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