Advantages of Currency Exchange Risk Management for Businesses
Every business knows that it’s impossible to avoid risk, but it is possible to mitigate it. For example, firms take out insurance against stock being damaged or destroyed. Businesses take out key person cover to protect against an important executive being out of action. And seaside kiosks make sure to have both ice cream and Bovril on hand to cope with variations in weather.
Currency fluctuation is just as much of a risk for businesses, and arguably an even greater danger. All it takes is a small movement in the exchange rate and — without any change in the demand for your goods — you may find that imported supplies rocket in price, or the revenue you get from exports collapses. It may even mean that you can no longer afford to sell at a competitive price in particular markets.
Even these cases can be comparatively bearable as you can adjust your business to accordingly. But other forms of exchange rate risk can be even more serious. Take for example a British firm that signs a deal to make some machinery to export to the US for a million dollars, payment on delivery.
If you signed that deal in January 2011, the firm would have expected that million dollars to be worth just under £650,000. But if it took four months to manufacture and deliver the goods, it would actually wind up receiving less than £600,000. Given the tight margins firms work on in today’s competitive markets, that could severely deplete or even wipe out the profit on the deal, and had the company had a crystal ball it would never have signed.
Of course, sometimes things work out the other way round: the same deal signed in May and completed in October would have seen the firm unexpectedly better off by £50,000. But that unpredictability is exactly the problem: things may go your way, but in effect you’d be gambling £50,000, which is no way to run a business.
The simple solution to such uncertainty would be to insist on completing the deal at a fixed exchange rate, or demanding payment in domestic currency, but that’s not realistic for many small and medium enterprises. Most firms can’t afford to play hardball in negotiating with big customers, and many smaller customers simply won’t bother with deals that bring extra hassle.
One answer that does work for many firms is currency risk management in the form of a forward exchange. This means making an agreement with a financial firm, (An example being TorFX Currency Exchange Rates) to complete a currency exchange at a fixed rate on a set date. In our example, the company could agree the rate when it got the machinery order, and then simply convert the cash when it got the payment, without having to worry about the prevailing market exchange rate at the time.
For those with more complex needs, there are tools such as a limit order or a stop loss order. The former allows you to set a desired rate and have the deal go through automatically when the market rate reaches that level. The latter lets you set a minimum or maximum rate at which the deal goes through automatically, meaning you are protected against the rate moving too far in the wrong direction for your needs.
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