Dynamic Export

Forward exchange benefits and drawbacks

The main benefit of a forward exchange contract is knowing how much money you’re going to get for a sale upon payment. Relying on the spot market makes this difficult.

For example, you might do a deal where you sell goods with a price tag of US$100,000 to a customer, with a payment term of 90 days. If, at the time of making the sale, the rate was US60c to A$1, then you would have received approximately A$166,667 had the customer paid on that day. However, 90 days down the track, if the rate became US80c to A$1, you would only receive A$125,000.

If you had instead entered into a forward exchange contract, it would have taken into account the spot rate and the interest rate of both countries over the quarter. The difference between the present and future amounts would have been a lot less.

This is extremely important for maintaining profit margins, says Keith: “It’s about how much their business can afford in terms of exchange rate changes. So if the exchange rate moves 30 percent, does it make the business unprofitable and put them out of business, or do they have such large margins that they can accommodate that?”

Certainty also has positive follow on effects including predicting cash flow and other types of business planning, so you may need to consider how having a forward exchange contract may affect other parts of your business.

A disadvantage of a forward contract is that you cannot take advantage of the rate if it moves in your favour. If you took out a forward exchange contract and a scenario occurred with the rate US80c to A$1 at first, then US60c to A$1 when payment fell due, you could have missed out on about A$40,000.

Managing risk

A halfway point is to use forward exchange contracts, but only for some of the amount you need exchanged. That way, your business is only partially exposed to currency fluctuations, and you can take advantage of any movements in your favour.

To do this you will need to understand how much exposure your business can handle and then combine the best of both the spot and forward rates in a ratio with which you’re comfortable.

And everyone is different, Keith adds: “Every business and every manager has their own individual risk profile so some people are happy to accept a little bit more risk and other people are completely risk averse.”

He says the current global recession has thrown up a few interesting scenarios, especially around the uncertainty of the business environment. This means you need to take care with anything scheduled for the future.

“People take forward exchange contracts against future sales or future purchases and when those sales or purchases don’t happen because their buyer goes out of business or can’t pay because of the economic situation, the contract between the bank and the customer still needs to be honoured,” he points out. “That can have a detrimental effect on a business’ cash flow. It’s important to consider those possible outcomes.”

But in general, interest rates around the world have all fallen and that means forward exchange rates haven’t been as crazy as the spot market, where Keith observes there have been “huge fluctuations in currency based on the state of their economy”.

The arpeggio of the spot market has seen this form of currency management retain its popularity. “People are still looking for forward exchange contracts to get some certainty because with the large movements they can’t afford the adverse ones,” says Keith.

“Obviously they kick themselves around the positive ones, but they couldn’t have it the other way, so people are still using them.”

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