Forward Thinking: Currency Risk

Currency volatility is a big concern for any treasurer that has to make international payments on behalf of their business. A sudden shift in exchange rates can dramatically diminish the value of a profitable deal or even, in an extreme case, turn it into a loss-maker. Attempting to understand the currency markets and mitigate against foreign exchange (FX) risk can be a real headache for treasurers, but knowing how to properly manage currency risks can be a real asset for any global business. 

The importance of managing currency fluctuation can be seen just by looking at the pound-euro exchange rates since the start of 2012. In this period, the exchange rate has varied from a low of €1.16 and a high of €1.29 to the pound, according to the xe.com currency converter website. This equates to a 9.32% difference in price throughout the year. The dollar has also fluctuated by 6.55% against the pound in the same period. These currency fluctuations can have a significant impact on a business’s profit margins. It is for this reason that, after several years of austerity in an increasingly globalised market, treasurers have had to become savvier in order to minimise costs and remain competitive against their peers. 

So, the question stands, how can treasurers effectively hedge against currency risk? 

Well, it should be known that there are a number of cost-effective tools and new techniques available to treasurers who are seeking to manage currency risk. By implementing these tools and methodologies, treasurers will be able to create and execute an effective international payments strategy that will help to protect their company’s finances in an uncertain market. 

Available Tools: Forward Contracts

A forward contract is perhaps the simplest and most effective tool available for treasurers seeking to manage currency exposure. It is, in short, a straightforward currency hedging tool. 

A forward contract allows treasurers to buy or sell a foreign currency at today’s market price, delaying the settlement of the contract to some future point in time. It means that treasurers can lock-in to a particular FX rate for an extended period of time (e.g. 12 months) and settle upon delivery at an agreed date. 

A forward contract is no different than a standard currency trade, other than the fact that the settlement date is pushed forward into the future. The forward rate is also adjusted slightly to account for the interest rate differential between the two currencies in question. 

A key part of a treasurer’s job is of course setting budgets, and knowing what they can realistically afford to spend. If they see an exchange rate that is better than what they have budgeted for, there is the opportunity for them to lock-in that rate for a 12 month period, which means they may find an unbudgeted FX gain – a great bonus for any business.  

There is one obvious downside to using a forward contract. On the day of settlement, treasurers are obligated to settle at the predetermined price. This means that there is a chance that the market rate on the day of settlement is more favourable than the predetermined forward rate. Whether or not that risk is worth taking is of course up to individual choice and circumstance. With today’s volatile market showing no signs of abating, however, many businesses are opting for some level of exchange rate certainty to protect against a sudden and damaging fluctuation. 

Clearly, by fixing the exchange rates of their international payments through forward contracts, treasurers will be in a better position to manage their outgoings. They will have a predetermined rate of FX for a specified amount of currency, allowing them to be better equipped to cope with unforeseeable market disruption and other external variables. In these times of uncertainty, businesses can look to control as much of their financial transactions as they choose. The bottom line is that fixing the exchange rate in advance eliminates exposure to volatility. 

Stop-losses

There is another cost-effective tool that treasurers should consider employing when managing currency risk. Any good treasurer should know what their worst case scenario exchange rate would be, and they would need to account for this accordingly. In order to ensure that the worst case scenario is never worsened, treasurers are increasingly making use of ‘stop-losses’, which allow treasures to specify the least favourable exchange rate at which they are willing to transact. 

By employing a stop-loss on a particular payment, treasures can place an order on the market which is fixed at the worst case scenario price. The chosen payments service will monitor the exchange rate and can automatically sell when the FX rate hits that price. This will help to ensure that the business’s bottom line is protected, as the treasurer will have already budgeted for the least favourable price. 

The advantage of a stop-loss is that it allows for some degree of flexibility while insulating against the worst effects of a negative rate movement. It is a product worth considering for treasurers who would prefer to monitor the market as it allows them to do so with what is basically a financial safety net that will keep them from hitting the floor should a currency begin a downward run. 

Future Payments

Cash is king in the current financial markets and with credit availability scarce, treasurers need to be aware of alternative sources of cash for when they need it. This is where ‘future payments’ come into their own as another useful tool for treasurers to consider in international business. 

A future payment is rather similar to a short-term forward contract, except it is more payment-specific. For example, by setting up a future payment, a treasurer can receive a short-term cash injection of up to £50,000. This is then set at an agreed exchange rate and settled within a 90-day period. The big advantage of a future payment is that it both protects against currency fluctuation and boosts cash flow, making it a strong tool for businesses that need access to funds while waiting for stock that they know will be delivered. 

Making use of some or all of these tools will allow treasurers to develop and execute a robust currency risk management strategy that reduces exposure to currency fluctuations. The three available tools outlined above are examples of actions treasurers can take to manage costs and protect profit margins – two issues with which treasurers will of course be familiar. Many treasurers are probably also familiar with at least some of the products mentioned here and may have been using these and similar tools to manage currency risk for a number of years. 

The nature of market volatility has not changed, but the suddenness and degree of that volatility has certainly become more pronounced since the credit crunch and start of the global financial crisis. With all major Western economies now making use of cost effective tools to manage their currency exposure, treasurers must adapt with the times or risk being left in the dust. The business world has become more globalised and that does not look set to change. By mitigating and minimising their exposure to currency risk, treasurers will help to ensure that their businesses remain competitive. 

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