When your business trades internationally, one of the key risks you must manage is foreign currency. If you are confused about foreign currency and want to know more, this article will help you understand and manage these types of risks. It follows on from my previous article for ITM, in which I introduced and explained foreign currency issues for businesses who sell or buy overseas. As before, I will assume a low level of knowledge of the terms and jargon involved.
Risk of selling to overseas customers
When you sell overseas, it is likely your business will be paid in foreign currency. For example, a UK business selling to a German customer will probably be paid in Euros rather than British Pounds Sterling.
Why is this a risk?
This is a risk to your profits. If the foreign currency in which you will be paid falls in value before you are paid, it will be worth less to you when the cash arrives. If you have a small profit margin, then this could even wipe out your entire profit on the deal.
How big is the risk?
The size of the risk is different for each business. It is usually driven by the following factors:
How long will you wait before getting paid? If you have to wait a long time to get paid, there is a higher chance that the currency values will change.
How slim are your profit margins? If your business model relies on a high volume of sales with low profit margins, then it only takes a small currency change to make a large dent in your profits
I’m just as likely to gain rather than lose, so what is the problem?
Foreign currency can go up as well as down. This means your business could get lucky and you might make extra profit rather than less profit. However you should not rely on this as an excuse for ignoring the problem. If you do not manage your risk, then you are in effect gambling on foreign currency markets that you have no control over. My strong advice is don’t try to make money on currency fluctuations from your business – if you do then ask whether you have become a currency trader instead!
How can I manage this risk without extra cost?
There are a large number of ways your business can manage these risks. Many of them are simple to implement and involve no extra cost on your part. Ask whether the following questions apply to your business:
Can you charge international customers in your own local currency?
If you are able to price your products and invoice your overseas customers in your own currency, then your risk goes away. In actual fact, you transfer the risk to your customer. Many businesses do not even consider this option but I recommend that you try to negotiate this, particularly for large deals which have a major impact on your bottom line.
Can you negotiate an increase in price if the exchange rate falls?
Some sales contracts include a clause to increase prices if the currency rate falls. If you can negotiate this with your customer, then you will receive more foreign currency and your risk will be eliminated.
Can you buy goods in the same foreign currency in which you are paid?
Another option is to deliberately switch some of your costs into the same foreign currency. In our example this will mean that the UK business has both income and costs in Euros. If the Euro falls in value, then the UK business has protection because it has lower costs as well as lower income.
Can you locate some of your business operation overseas?
You may also be able to recruit staff and have business operations overseas. This is another way of switching some of your costs into the same foreign currency in which you are paid. This is particularly useful if you can predict confidently that a large part of your income will be in a particular foreign currency.
Paying to manage currency risk
If none of the above options are practical for your business, then you can manage the risks by buying foreign currency tools. There are a bewildering array of these tools, they can be very complex and they can add other types of risk. Many providers will intentionally or otherwise blind you with jargon, and you cannot rely on them to understand and explain all the risks. The simple guide below will help you to understand what you are buying and why.
Buying currency at a future date
It is possible to buy foreign currency at a future date at a fixed price. If in our example the UK business will receive 10,000 Euros in a month’s time, it can make a contract to sell those Euros into British pounds in a month’s time for a fixed exchange rate. This guarantees that UK business will receive a fixed amount of cash in British pounds, so the business is protected from any changes that may happen in the currency market. In the jargon, this is known as a “forward’ contract.
Be aware that these contracts carry their own type of risk. They are binding, so even if you do not receive the customer cash you still have to fulfill the contract.
Can I have the option not to buy the currency if rates move in my favour?
You can purchase a currency option. This is similar to a forward as it allows your business to buy foreign currency at a particular rate in the future. However it also gives you the option not to fulfill the contract if the currency markets have moved in your favour. An option is more expensive than a forward, so it will cost you money to purchase.
How can I buy these currency tools?
These tools are typically readily available if your business operates in :
a hard currency, i.e. a currency which is widely traded internationally
an economy without capital and exchange controls
Your bank should be able to offer these tools. There are also a fast-growing number of specialist foreign exchange providers.
How can I choose a currency supplier?
Look for a currency supplier who has the following characteristics:
Fully registered and compliant with your appropriate financial regulator
A substantial and reliable trading history
Strong customer base and recommendations
An easy to use and secure online currency management tool. This should make it easy for you to buy and sell currency and compare exchange rates
Patient and long-term approach to building a relationship with you.
Risk of buying in foreign currency
This article has focused on companies who make sales in foreign currencies. However many businesses have a currency risk because they need to pay for goods in foreign currencies. For example, airlines have to purchase their fuel in US$.
The risks and mitigating actions are the same in principle for these businesses, except they need to do things the other way round. Eg they can try to purchase in their own local currency, they can try to increase sales in foreign currency or they can buy a forward contract to buy currency.
I hope you have found this helpful. If you have any further questions about currency, please ask a question to our user forum at www.galvininternational.com. Or contact me directly at firstname.lastname@example.org.
John Galvin MA ACA, has 20 year’s experience in CFO and other senior executive positions with multinational Blue-Chips and SME’s. He regularly contributes to international finance events and publications. His company, Galvin International, www.galvininternational.com provides international accounting, tax, payroll, HR and legal services in over 50 countries.