The Bretton Woods agreement in 1944 laid the foundation for the current global monetary regime. Even though later in 1971, the then US president, Richard Nixon, stopped pegging the value of the US dollar to gold, most of the pillars of the global monetary regime have remained in place until today.
Currently, most countries have a floating exchange rate regime in which buying and selling activity determines the value of the local currency against other currencies. This has its benefits. However, businesses that use more than one currency are exposed to foreign exchange risk, and they must have a clear risk management strategy to keep FX risk in check.
This short guide will highlight the main types of foreign currency risk, examine some risk mitigation steps businesses can take, and explain when each step is more suitable.
Choosing a reliable currency exchange partner is often the biggest part of the answer, as it enables you to consult with experts on how to mitigate exchange rate risk and gives you access to all the tools you need in one place.
What are the risks of foreign exchange?
Your assets, liabilities, sales, cost of goods sold, administrative expenses, and other cash flows are usually denominated in a currency such as Pound Sterling, Euro, USD etc. This means that currency exposure is almost inevitable for international businesses. Below are some risks you need to be aware of to manage this exposure.
Transaction risk
This risk usually materializes when there is a time difference between when the payment is accrued and when it is received, such as when you buy or sell on credit. The value of this credit may change dramatically between the rate at the time of purchase and payment, resulting in loss of earnings.
Translation risk
If you manage a parent company, you must present consolidated financial statements in your home currency to the tax authorities at the end of the financial year.
If you receive payments in foreign currency, you must translate them to your home currency before submitting your tax forms to the authorities.
For example, if your business headquarters are in the UK and you sell your products in Germany, you will likely receive payments in Euros and will need to translate them to Sterling based on a given exchange rate when you report them.
There might be a difference between the rate you use when you translate your financial statements and the effective exchange rate when you convert your Euros to Sterling. This can also result in variance in your profits.
Operational risk
You may be tempted to enter a foreign market because labor costs are lower. However, if your new business domicile’s local currency appreciates significantly, this will outweigh the cost advantage you thought you had.
Similarly, if you enter a new market because of the high purchasing power and the local currency loses value, purchasing power will erode. You won’t have the same advantage you presumed.
Operational risks are long term in nature, which means that you need to have risk management strategies before venturing into a new market.
Foreign exchange risk mitigation techniques
Currency fluctuations are the root cause of all the above risks. But financial markets offer tools that help you eliminate them. In some cases, these risks can turn into opportunities, and you may increase your earnings. Below are some foreign exchange risk mitigation strategies and techniques you might consider.
1. Buying forward contracts
A forward contract is an agreement between two parties wherein the seller agrees to sell a currency at a predetermined exchange rate to the buyer at a specific point in the future.
Example
You agree to buy 10,000 GBP in exchange for Swiss Francs at a 1.28 GBP/CHF exchange rate within six months, even though the current exchange rate is 1.22.
This reduces your exposure to both GBP appreciation and Swiss Franc depreciation, though not without risk. This contract is beneficial for the buyer only if the exchange rate does not spike. If it goes above 1.28 (say, to 1.35), it will be more favorable for the buyer. Thus, businesses must make robust forecasts before entering into such contracts.
Tips for buying forward contracts
- Assess your foreign currency needs in the future, depending on your demand forecasts and input requirements. Be sure also to indicate when you will need to exchange currency.
- Make educated forecasts about the direction of the exchange rate. You can use macro indicators, such as growth and unemployment, and monetary policy decisions, such as potential interest rate hikes to make your predictions sound.
- Only buy a forward contract when you see a significant risk (above 70%) that you want to avoid. In other words, make sure there is a good justification for your decision.
2. Buying currency options
Currency options may be a better choice to help you mitigate foreign exchange risk. These contracts give you more flexibility and protect you from risks associated with forward contracts. A currency option gives you the right but not the obligation to buy a certain currency at a predetermined exchange rate before an agreed-upon date.
Example
Let’s assume you want to pay for a shipment from South Africa in the future, and you want to reduce your exposure to the South African Rand.
The exchange rate is currently at around 15 USD/ZAR. You buy a put option on the USD/ZAR (to sell dollars in exchange for Rands) at a low exchange rate such as 14 USD/ZAR (to enable you to get more Rands per US Dollar) with a three-month expiration date.
Here, there are two scenarios.
- If the dollar appreciates to 16 USD/ZAR, you can exercise your options and buy the Rand at 14 USD/ZAR rather than 16 USD/ZAR.
- If the Rand appreciates to 13 USD/ZAR, you can ignore the option contract and buy the Rand at the market rate to be favorable.
Even though this contract is more flexible, you need to compare the cost (the option premium) with the potential benefit, depending on how you expect the market to move.
Tips for buying currency options
- As with forward contracts, you should assess your need for foreign currency in the future depending on your demand forecasts and make educated forecasts about the direction of the exchange rate.
- Calculate the mathematical probability of the exchange rate moving in your favor and reaching a profitable level. It should be at least a 70% or 80% probability.
- Compare the cost of the currency option (premium) with the potential gains.
- Only buy the currency option when benefits outweigh the costs significantly.
3. Build a solid position in the market to have more bargaining power
Companies with a dominant market position have the bargaining power to choose the currency in their transactions.
Example
Companies selling microchips are in a good position today due to the shortage. They can ask customers to pay in their home currency, such as USD or Japanese Yen. This strategy may not be applicable in highly competitive markets.
Tips for building a solid market position
- Be extremely customer-centric and build a strong brand. Companies like Amazon managed to reach their strong position because of their relentless focus on meeting customer needs. They can ask the customer to pay in USD or any other currency as a default option.
- Build trust and long term relationships with your suppliers. If you are a major customer of your suppliers (i.e. they get a significant portion of their revenue from you), you can ask them to send you invoices in your home currency. They will usually agree, given that they want to keep your business.
4. Have currency reserves
Central banks maintain reserves to ensure that they can withstand inevitable market fluctuations. You can do the same. You can maintain reserves in the currencies you use the most to convert those reserves from one currency to another only when the exchange rate is feasible.
This strategy is more advanced and primarily suitable for large businesses that can afford to maintain such reserves. However, if you have the necessary financial cushions and have the expertise to manage them, then this can be a good option.
Tips when building currency reserves
- Build your reserves based on your business needs and sound forecasts of exchange rate movement.
- Ensure your reserves are balanced and not overly concentrated in one currency.
- Think long term, and rebalance your portfolio of currencies when necessary.
- If you have a very long term strategy, then investing 10% or more of your portfolio in gold might be a wise choice to offset the impact of inflation.
Key takeaway
Your currency exposure is a critical factor that can influence your financial results for better or for worse. Thus, you need to have the right knowledge, strategies and tools in your arsenal to respond to those risks quickly and to benefit from market volatility rather than lose out. Work with a currency expert to gain access to advice on the best course of action to process your transactions securely and with low risk.
