Payments in foreign currencies are not new for many UK-based importers and exporters. Businesses that often trade with different currencies are at risk with volatile exchange rates. When conversion rates fluctuate, costs and profits go up and down as well.
It is important for any business to be aware of these risks and what they can do to manage them. Especially for those in the import and export business and those who want to scale!
For large businesses, great risk must be dealt with equally great, if not greater, risk management. To do so, they use effective strategies and tools to cut costs and max profits. Strategies and methods most small and midsize businesses don't know of. As a result, SMEs become more exposed to risk and least prepared to manage it.
Currency risk refers to the risk of losing money because of changes in exchange rates. When there is a time gap between the agreed sale of foreign currency and when the actual transaction takes place, a business becomes vulnerable to currency risk. It's a kind of risk that's better known as transaction risk.
Exchange rates can change drastically for the worse. Such risk exposes importers and exporters to potential losses. Import purchases can cost more than expected. And export profits hang by a thread before the deal ever goes through.
While exchange rates can move favourably, many assume that doing nothing is a safer option. Yet, companies that leave themselves in the open often lose out against these risks. When currency fluctuations can cost you thousands, it’s hard to say you can just go with the flow. I guess Ben Franklin was right, "failing to prepare is preparing to fail."
There's a lot of uncertainty that comes with trading foreign currencies. Even if it’s hard to predict when rates go up and down, preparing for any sudden drops gives a business more stability. Not anticipating how much to receive or spend on foreign transactions can disrupt how the business operates. External factors like exchange rates are difficult to control. Maybe even impossible! But, you can definitely be in control of how much cash flow goes in and out of the business. It doesn’t hurt to be wiser with FX costs and know the ins and outs of the market. Recognizing what usual prices are can put you at an advantage when rates change significantly all of a sudden.
Foreign exchange (FX) risk management otherwise known as FX hedging helps companies fix exchange rates to a future date. It's a popular strategy alternative to exchanging currencies through the usual channels like banks and brokers. FX hedging protects trades from unfavourable changes through ways like forward and option trades. We cover these two better in a different, more in-depth article. You can check it out here if you want. Anyway, let’s start with forward trades.
With forward trades, you can fix an exchange rate into the future. This is useful for importers and exporters who want to protect their international transactions. They can also potentially save money with forward trades. Any company can make trades like these by using a third-party provider. With these, they can pre-arrange exchange rates to a future date. How does this work?
For example, a British exporter receives an order from an importer in the US. The American importer will need to send their payment first in pounds but want to make sure they get their order first. So, they will want to pay for it in the future.
But, exchange rates can change anytime between the day they make the sale and when the order arrives. So, the exporter in the UK wants to make sure the payment comes on time and in full without a single pound missing. At the same time, the American importer wants to avoid the risk of paying more in the future. So, they decide to pay with a forward trade.
To do so, they would need to use a forward trade with a third-party currency exchange provider like Bound. Bound can fix an exchange rate for them in the future in case prices change against their favor. The third party also makes sure payment gets to the exporter on time. Even if future exchange rates (spot prices) change, they can still convert their euros into pounds with rates they agreed on during the sale.
So, if they agreed to pay when 1 USD is equal to 0.70 GBP. And 30 days later, on the day the order arrives, 1 USD suddenly changes to 0.75 GBP. If the order costs them just 70,000 pounds back then. Adding 5,000 pounds to the price tag would definitely be unfavourable. With a forward trade, the £70K order they agreed upon stays the same even if prices change.
As a result, exporters will know exactly how much they receive in their currency. And importers will know exactly how much they'll pay without huge potential losses.
Sounds great! But, there's one disadvantage to forward trades... Once anyone makes an order for it, they're contractually obliged to complete the currency exchange. So, if rates suddenly make the order let's say 2,000 pounds cheaper on payday. They still have to pay what they agreed upon.
Sometimes, companies are unsure or come to a situation where they don't want to go through with the transaction. For example, if there are order delays or sudden quality issues. Option trades can often be a better choice.
Option trades also allow businesses to set an exchange rate for a future date. The only advantageous difference they have from forward trades is the lack of contractual obligation. Unlike forward trades, options give a company an option to opt-out of the trade hence the name.
These are particularly useful for speculative situations such as a company expecting to convert currencies in the future but not sure if they will go through with it. Having the option to not exchange currencies in the future allows a company to benefit if spot prices change in their favor. In other words, cheaper.
If ever prices don't change to their favor. Option trades still let the company exchange currencies at the future date. It's basically a forward trade that you can cancel if ever exchange rates in the future cost less.
For example, your order arrives late or is not in a good "sellable" condition. You can opt to not pay the exact amount and settle the issue without a loss. Another good example would be if you're making a transaction with a long-term business partner of yours. And you two speculate or are open to changing the agreed exchange rate if ever prices get cheaper, an option trade lets you do that.
If ever you find forward and option trades not the best choice to hedge FX risks for a particular situation. There are other ways to hedge FX risk as well:
Internal FX hedging is when a business uses resources that are already available to them. They won't need to use a third-party provider to hedge their risks.
With FX hedging, exporters charge customers in their domestic currency to avoid exposure to fluctuating exchange rates. While this removes the risk for the company, it puts customers at risk instead, potentially hurting sales.
If a company is unable to do this, an alternative method would be to do ‘leading and lagging’. With this alternative, the company exchanges foreign currencies only conversion rates are favourable. One example would be withholding payment until rates favour both parties. While 'leading and lagging' can be effective, it takes too much effort and risk because of how unpredictable rates can be. Who knows "when rates are favourable"?
Another internal way of FX hedging is through a risk-sharing agreement. With a risk-sharing agreement, both parties agree to split any financial differences caused by fluctuating exchange rates. Take note, this doesn't reduce risk at all. You're merely just sharing it.
If companies don't want to share risk, then something less risky like currency futures may be used. Currency futures are like forward trades except they're offered as standardised products. This means the third-party provider you use sets the amount and dates you can only exchange your currency.
With a forward trade, a company can decide on the amount, exchange rate, and date of the transaction. Currency futures work the same way but the currency exchange makes those decisions. Exchanges offer futures in set amounts and dates you can make a conversion. Because of this, they are less flexible than forward trades and take all custom transactions away.
With a money market hedge, a company can use the money markets to either lend or borrow money in a foreign currency.
A business creates a money market hedge in anticipation of a foreign currency transaction. To do so, the business converts the desired currency at current rates. And deposits it in a money market and earns interest or borrows it. When the time comes for them to complete the transaction, any future change to the current exchange rates will not have an effect.
Once the company receives the money they've made from the transaction, they can then use it to pay the money market hedge.
There are a lot of ways to manage FX risks and no one method fits all needs. There will be situations where you'll need a forward trade over options or currency futures. Sometimes, you'll want to do a money market hedge. If you've got the resources and reach, why not do internal FX hedging instead.
Many companies don't have the time to learn about hedging, so use software tools where everything from the spot, forward, and option trades are available for you. Technology is making FX hedging simple that anyone can do in a few seconds. If you're still not ready and want to find out more, you can take a look at free resources to help walk you through it. You can start with this intro blog on Foreign Exchange for SMEs: How to Get Protected from Currency Risk.