SUBSCRIBE TO OUR FREE NEWSLETTER
PUBLISHED |

Managing foreign exchange risks

Author:
Managing foreign exchange risks article image

The foreign exchange market is the most liquid and most critical financial services market in the world. With an enormous US$2.5 trillion estimated in trade every day, the forex marketdwarfs the combined trading volume of all the world’s stock exchanges.

For many Australian exporters, the sheer size, scale and complexity of dealing in foreign exchange can leave them confused and bewildered, but it doesn’t have to be so. By adopting a number of simple strategies, business owners and managers can take control, mitigate risk and develop a much stronger level of certainty regarding this essential part of their business.

Beware of volatility

The first thing to understand about forex markets is that they are dynamic, ever changing and sometimes extremely volatile. As an example, over the 16-month period covering July 2008 to November 2009, the Australian dollar to US dollar (AUD:USD) exchange rate traded as high as 1:0.98, it then dropped to 1:0.60, only to climb back to 1:0.94. For a company where export generates most or all of their revenue, such extremes in currency movements can obliterate their cash flow and therefore their profitability.

From an exporter’s perspective, the risk inherent in selling your product in a foreign currency is that if the value of that foreign currency falls, it impacts on the amount of local currency you can ultimately bank as revenue.

As an example: Company X receives an order they invoice out for payment in three months to the value of US$100,000. Their price takes into account the AUD:USD exchange rate on the day of 1:0.85 therefore Company X expects that deal to equate to AU$117,647 in revenue. However, in three months’ time when the US dollars arrive, the exchange rate has risen to 0.95, thus only netting AU$105,263, which is a significant amount of AU$12,384 less than expected.

Aim for stability

Generally your goal in developing a foreign exchange risk management program is to stabilise your cash flow and gain a higher level of certainty. There are four primary ways to achieve this: Invoice in Australian dollars: The ultimate method to protect your business from currency movements is to invoice in Australian dollars and therefore remove the necessity to exchange altogether. In reality, however, this is often very difficult to accomplish and may dilute your value to prospective customers. The vast majority of exporters we partner with are focused on finding as many customers in as many markets as possible. The last thing they want to do is create extra hurdles that may render themselves uncompetitive. Open a foreign currency account. It may be worthwhile to consider opening a foreign currency (FC) account, particularly if you only deal in one of the major currencies such as US dollars. Your customers can transfer funds directly into this account and you then have the ability to covert into local currency when the rate is preferable. Of course, your ability to hold funds in an FC account over a period of time will be determined by the strength of your cash flow. If your business model includes both import and export in the same foreign currency, then an FC account is almost mandatory as it provides you with a natural hedge. Always remember it is important to gain a clear understanding of what fees and charges are applicable for holding a FC account to ensure the expense doesn’t outweigh the benefit. Consider forward contracts. The majority of exporters, particularly small-to-medium-sized companies, only use spot transactions, in other words, the prevailing rate on that particular day, to manage their forex requirements. Most are unaware they may be able to hedge their forex exposure via a forward exchange contract. A forward exchange contract (FEC) is a contract to exchange one currency for another, for example to sell US dollars to buy Australian dollars, at a specified rate, for a specified amount, for delivery on a specified date some time in the future, although almost always within 12 months.

To expand on the example from earlier, Company X decides to cover, or hedge, their sales contract and they lock in a forward exchange contract to sell US$100,000 and buy Australian dollars in three months’ time at an agreed rate of 0.84 (indicative only), thus guaranteeing them AU$119,048 when the contract matures. This FEC rate, and therefore the final payout amount, is locked no matter what the exchange rate does over the prevailing three months.
The forex rate applied to this FEC is calculated by adjusting the spot forex rate by a margin. The spot rate is the foreign exchange rate quoted for immediate delivery of foreign exchange, and the margin reflects the interest rate differential of the currencies involved, which can be either positive or negative.
By entering into this FEC, the customer has certainty regarding the amount of Australian dollars they will receive on completion or maturity date, and therefore more effective cash flow management.
It is important to understand that an FEC is a binding contract to exchange (buy or sell) one currency for another and that there is an element of risk associated with this product if you are unable to meet your obligation. With all such products, it is in your best interests to fully read and understand all relevant literature, such as product disclosure statements to ensure you are across the detail and aware of your responsibility.
There are also more elaborate hedging products available that are generally lumped under the term ‘options’. While these may be of value to some larger organisations with very sophisticated forex needs, the majority of small-to-medium-sized businesses can develop a sound forex strategy using spot and FEC products. A general guiding principle in such matters is the more sophisticated the product the higher the risk.
Find a forex partner. The final piece to your forex strategy is, in my opinion, the most important. That is to partner with a foreign exchange provider who is able to exhibit real and demonstrable value to your business on a number of fronts. The pillars of this relationship should include personal service through a dedicated forex specialist, an understanding of your business and payment cycle, relevant market commentary and analysis, a secure and intuitive trading platform so you can transact with confidence, all underlined by a reputable, reliable and secure brand.
While some customers still adopt a ‘panel’ approach to sourcing a forex provider, in essence shopping around in an attempt to secure a marginally improved exchange rate, we are working more and more with companies who are looking to establish long-term, constructive and collaborative partnerships. If you have found a provider that ticks all the boxes that are critical for your business it makes sense to leverage that relationship and plan cooperatively for future growth.

Review and monitor

Once you’ve developed and enacted your forex strategy the final piece to the puzzle is to regularly review and monitor the effectiveness of your plan and determine what outcomes have been realised. An annual review will allow you to continue and enhance the successful aspects of your strategy and refine those areas that did not meet your expectations.
By adopting these basic strategies, Australian exporters can introduce a level of certainty and control to their forex needs, which should once and for all take the ‘foreign’ out of foreign exchange.
-Barry Fletcher is the director of Business Development for Australia and New Zealand at American Express Foreign Exchange International Payments (www.americanexpress.com.au/fxip) and Dynamic Export’s foreign exchange expert.

Tags

Leave A Comment

Spinning icon Saving your comment, please wait...
Spinning icon Saving your comment, please wait...
SUBSCRIBE TO OUR FREE NEWSLETTER