Using foreign currency to manage business risk
In a globalised economy businesses are finding themselves more and more exposed to what is referred to as “Exchange rate risk”, “Currency risk” or “Foreign exchange risk.” This is where a company has to deal or report in more than one currency which opens the company up to several forms of exchange rate risk.
- Transaction exposure – A company that imports or exports goods or services overseas that involve terms of credit, such as 90 day payment terms, will find themselves watching the exchange rates like a hawk up to the settlement date as any movement between their domestic and settlement currency could cost them thousands.
Example: A £1m order placed in the first 6 months of 2013 could have fluctuated in value by up to £150,000.
- Economic exposure – When a company deals solely within its domestic market (nothing imported or exported) it is only vulnerable from fluctuations in that particular market. However when a company is reliant on foreign goods or customers they are vulnerable to the impact their own economy has around the world. For instance if the UK is doing well as an economy then it’s currency will strengthen and goods sold abroad will become less competitive and if the UK economy starts to struggle then the currency will fall and imports will become more expensive having a knock on effect on company’s bottom lines.
- Financial Translation Exposure – Depending on how a company is structured then its financial reporting requirements can mean that all transactions be reported in a different currency from the one that the company conducts its business in. This opens the company up to the risk that the currency or economy of the reported currency moves significantly to the currency that it does business in. A secured contract reported as an amount in one currency could be significantly different once payment is made and the exchange rate applied.
Ways companies protect themselves against “Exchange Rate Risk”
- Buying forward – A company uses a broker to buy an amount of currency at a set rate now for delivery at a later date.
Example: A UK import company placing an order in US Dollars to be payable in 6 months time. The UK company would like to make provisions for this payment but would like to know an exact amount. The UK company can buy the required amount of US Dollars now securing the current rate of exchange but for delivery in 6 months time. This way the UK company knows the exact amount of Sterling to put aside.
- Selling forward – The opposite of this would be securing a rate for currency you expect to receive at a future date.
Example: A UK exporter sells its goods to a foreign company in Euros which will be payable in 6 months. The UK company wants to be able to forecast its cash flows and would like to know an exact figure. The UK company can use a broker to agree to sell the agree amount of Euros at today’s exchange rate for delivery in 6 months time. This allows the UK company to record the sale and forecast its cashflows after this date.
Companies can use these techniques to offset all the risk or part of the risk. A company could decide that it would like to secure half the order value at a set rate and settle the remaining half at the rate at time of settlement.
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