Ways businesses can mitigate the risk of currency fluctuations.
October 30, 2019
Currency fluctuations are a reality that millions of SMEs all over the world must contend with. Currencies are always quoted in pairs, with a base currency and a quote currency. One currency is sold and the other currency is bought in the same pair every time there is a forex transaction. For example, the GBP/USD pair has the GBP as the base currency while the USD is the quote currency/counter currency. It indicates how much each GBP is worth in USD. An exchange rate of 1.29 indicates that £1 is worth $1.29. Since businesses deal with international suppliers and customers, there is an inherent degree of financial risk involved. This is true whether a business is selling products and services, or buying raw materials and supplies.
It is possible to mitigate currency risk by using a variety of tools, techniques, and resources to guard against adverse effects to a company’s cash flow. If revenue is derived in one currency, and costs are borne in another currency, there is an underlying degree of financial risk. If a US-based business has a factory in the United Kingdom, any unfavorable change to the cost factor, vis-a-vis the value of the GBP will impact the bottom line when products are sold in the US.
A basic example highlights precisely how currency risk plays out in practical terms. Assume that the prevailing exchange rate (spot rate) for the GBP/USD pair is 1.29. If it typically costs £100,000 to produce a piece of machinery that is shipped from the UK to the US, the cost in USD is $129,000. However, if the UK negotiates a favorable Brexit deal, and the GBP appreciates relative to the USD to 1.35, the cost in USD is now $135,000.
Since the sale price in the US stays constant (customers are loath to pay more based on exchange rate fluctuations) there is $6,000 less profit available to the SME on each piece of machinery that is produced at that exchange rate. Of course, exchange rates can also work in a business’s favor when the GBP depreciates relative to the USD. Assuming a complete breakdown of Brexit negotiations and the UK crashes out of the EU without a deal, the exchange rate may drop to 1.18. In such a case, the same piece of machinery will only cost $118,000 to produce, generating $11,000 more profit for the SME if the sale price remains constant.
How can businesses operate with such whipsaw activity in currency fluctuations?
Hedging Strategy Advice: Clearly, businesses don’t want to roll the dice every time they produce products abroad, sell to foreign customers, or buy from foreign suppliers. There are ways to mitigate financial risks by agreeing on a transaction value ahead of time. SMEs can require that payment is made after a contract is signed, at the agreed upon exchange rate, or alternatively payment can be made when the products are delivered. Rather than quoting the foreign currency and subjecting the business to a depreciated value in local currency, it is possible to agree ahead of time that the sale price will be made in the local currency.
In the case of the above example, the business could agree to purchase the machinery in USD upon delivery (the price is fixed), thereby mitigating all possible exchange rate risks. By hedging with forward contracts, businesses agree to purchase forex at a later date at a fixed exchange rate. These contracts can be purchased a year in advance, or up to 5 years into the future. Of course, a caveat is in order: currencies rarely conform to anybody’s expectations. Geopolitical factors can create wild fluctuations in price, and supply/demand considerations can easily influence currency rates.
Forex Swaps: foreign exchange swaps are one of the most useful hedging tools available to SMEs dealing with international stakeholders, customers, and suppliers. This tool goes by the name FX swap. With this tool, there are 2 transactions at play. An identical amount of one currency is bought and sold simultaneously. Some 49% of all foreign exchange trading activity takes place in the form of a fixed swaps. Buyers who understand that they will be needing their base currency in the future routinely engage in FX swaps. In the case of the GBP/USD example above, the US-based business understands that it may need GBP to pay workers, production costs, rent, and sundry expenses in the UK.
The spot option is risky since nobody knows what the exchange rate will be several weeks, or months down the line. An FX swap allows short-term financing in one currency and the company can receive the funds at a future date in another currency – sans exchange rate fluctuations. It is worth pointing out that the forex swap option is based on the spot rate of the currencies in the pair. FX swaps require a deposit of approximately 10% of the swap value for the contract to be effective.
Currency Swaps: this is a cross-currency interest rate swap, which is also a derivatives product. It is used when there is a differential in interest rates between countries. For example, the interest rate in South Africa is significantly higher than the interest rate in the US. It therefore pays to borrow money cheaply in the US. When a US-based company is seeking a loan in South Africa, and the South African company is seeking a loan in the US, the two companies can agree to a currency swap whereby the two companies remove interest-rate risk and exchange rate risk.
While some companies fancy the idea of an in-house treasury to act as their own bank to stabilize prices, this is not necessary with the wide range of tools available to mitigate exchange-rate risk nowadays