By James Butland, VP, Global Banking at Airwallex
Traders and businesses alike know that any currency can experience periods of high volatility. Right now the current COVID-19 pandemic and associated economic disruption has introduced high levels of volatility into foreign currency markets. We’ve not seen this situation since the 2008 global financial crisis.
Any business that relies on importing or exporting goods will fear these times since such volatility can make or break them. Yet risks may be minimised with the right measures in place.
Understanding the risks
Foreign exchange risk is that imposed on an international business as currency exchange rates change rapidly. This can markedly affect financial performance. These fluctuating exchange rates can damage a business’ profitability by eating into margins, not to mention the added stress caused by lack of stability. Essentially, any situation in which a business uses foreign currency can be considered a foreign exchange risk. Businesses operating with multiple currencies are the ones most at risk to high rates of volatility.
Businesses will find that these risks can come from:
- Receiving income of any sort, including interest, dividends, royalties, and revenue in foreign currencies
- A requirement to make payments in foreign currency to others, like suppliers
- Any business loans made in foreign currencies
- Holding offshore assets, such as international business subsidiaries
There are a number of ways that volatile exchange rates can impact your business. If you’re an importer a falling domestic exchange rate can increase import costs, damaging your profitability. A UK business importing from the US would find a fall in the pound harmful. And as an exporter a falling exchange rate typically benefits you as your product pricing will become more competitive. However a rising exchange rate will be harmful to your product pricing. Such movements aren’t predictable with any certainty, though board brush educated guesses will help smooth the situation to an extent. If you’re a local producer, rising domestic exchange rates can give importers more of a competitive edge over your products, and you lose your business to overseas producers.
Manage the risk
While typically, volatile exchange rates can make a business nervous, there are a number of proven strategies that enable effective hedging against foreign exchange risk.
Spot transactions, or spot contracts, are one of the easiest ways to manage foreign investment risk. A spot transaction is a single foreign exchange transaction where you purchase and settle the amount ‘on the spot’ (within two business days). It provides very little notice time, and a shorter window for risk, so if you’re happy with the current foreign exchange rate, you can book in a conversion with a spot transaction. While this might mean you forego a better rate in the future, it does minimise the risk of future volatility in your desired foreign currency right now.
A Forward Exchange Contract (FEC) allows your business to guard itself against price fluctuations by locking down an exchange rate at the current price, which is valid until a date set by you. While this contract provides peace of mind that you won’t actively lose money on your foreign exchange, it does mean that you can’t take advantage of any positive shift in foreign exchange rates either. A downside is the fees imposed on this. A FEC locks in a specified sum of money. So for example, if you lock in US$10,000, but at the end of the contract you only needed US$8,500, then there is a contractual cost to cancel this remaining portion.
A natural hedge is ideal for businesses that are already selling overseas. Foreign currency bank accounts can be a great way to provide this natural hedge. Many offer local account details in multiple currencies, all within the same ‘virtual wallet’ so it’s easy to manage, hold and convert money in the same place. Rather than receiving in USD and converting to GBP, you can leave your USD balance in your USD foreign currency account. This is especially convenient if you have expenses also in USD as you can hedge against any fluctuations in GBP by just holding the USD in your account. You also save on any potential double conversion fees the banks may charge (for example, converting from GBP to USD and then back again later).
Foreign currency bank accounts are a simple way to manage foreign currency risk. To hedge against risk, simply deposit the required amount (plus a surplus). This allows you to make the most of FX rates when they’re strong by converting and holding the foreign currency until you need to make the payment. It also ensures the correct funds will always be available and takes into account the potential fluctuations of the currency.
Putting risk in its place
There are many options, although as with most risks, you can only reduce them, not eradicate them entirely. It’s well worth considering how to make the most of managing the effects of foreign exchange rates. Not only can you improve business margins, it’s even possible to make gains too for a little extra income – even if it’s not a predictable source of revenue.