Measuring FX risks when exporting
Rob Affleck, Head of Corporate at BExA member Currency UK shares how exporters can measure and protect themselves against the FX risks associated with trading in multiple currencies, using international suppliers, and buying and selling in overseas markets.
Understanding when your bottom line may be at risk due to exchange rate fluctuations is extremely important, perhaps even more so in the current climate. By not recognising the risks early enough and acting while in a position of strength, you will continue to leave your profits in a vulnerable position.
Due to the looming risk of economic struggles post COVID-19, businesses are moving away from attempting to get lucky on the way exchange rates will move and instead, locking in profits and protecting cash flows is the order of the day as businesses seek confidence in a time of frequent market volatility.
To understand your risk exposure, you need to understand when your business is at risk from fluctuations in exchange rates. If you deal in multiple currencies, use international suppliers, and buy and sell in overseas markets, you are at risk the vast majority of the time. To be able to create an effective FX strategy it is crucial to know which parts of the business are most at risk as well as understanding how to combat these risks. What determines this varies from business to business but by considering which currency pairs are being traded, how much of a buffer you have protecting your profit margin and lead times in the manufacturing or delivery process, you can get a clearer picture of where you are most vulnerable.
What are the lead times?
As an exporter, the price you sell at to your customers and the value of your profits in your home currency are the two key areas where you are most at risk to currency movements. This is particularly the case when we take into consideration the time between a business transaction being confirmed and the payment for the product or service being settled. For example, if a UK company makes a sale to a European client and will receive payment in euros in 30 days' time, a 10% drop in the EURGBP exchange would see your profits cut by 10%.
To experience a drop in profits such as this due to circumstances outside of your control is something that needs to be taken seriously and measures to protect against such movements need to be implemented into your business’ financial strategy.
The more time there is between the sale and receiving payment, the greater the chance of significant movement in the market. However, as we have seen over the last 6 months or so with the effect of the coronavirus pandemic, exchange rates can soar or fall dramatically in no time at all, meaning even if you operate using short payment terms, you are still at risk.
The important thing is to ensure that you stay one step ahead and have a proactive foreign exchange strategy as opposed to a reactive one. This can be done in a few different ways through the use of hedging products such as forward contracts and market orders that allow you to secure the foreign currency you will need when the exchange rate is in your favour. A forward contract allows you to agree on a fixed exchange rate that you can pay for at a later date meaning fluctuations in that currency pair won’t affect the rate you are able to buy at, and your bottom line is protected.
It is also worth considering that there is a lot of flexibility in the way you can implement this into your business’ financial strategy. While some choose to secure 100% of the rate they need at a time when it is in their favour, others choose to buy 50% of what they will need and leave 50% on the table to be able to react in the scenario that the rate goes even higher. There is far more risk associated with this method but it can be more beneficial to companies who may have a reduced cash flow due to the impact of Covid-19.
The way in which you choose to utilise a hedging strategy is dependent on your business and industry and is something that you can work through with a foreign exchange specialist. The important thing is to implement one as soon as you can to start protecting yourself from the volatility that is likely to occur for the remainder of 2020.
What currencies are involved?
Any currency pair can be affected by sudden movements in the market but it is important to consider where you are most vulnerable within your business. The simplest way to determine this is to look at which is the primary currency for your business and which other currency you exchange with it most frequently.
It may be that 90% of your business is done in euros and mainly traded with the pound. Naturally, the EUR/GBP pair is where your vulnerability lies as it is responsible for the vast majority of your costs and profits. However, whilst this can be used as a starting point, there is much more to consider than just the amount of your business that is going through one particular currency.
There are some currencies that are considered to be safer than others such as the US dollar, Norwegian krone and Singapore dollar. Whilst on the flip side there are certain currency pairs that are more volatile like GBP/AUD, AUD/USD, and CAD/JPY. These currencies that are more volatile should be considered a greater risk and therefore prepared for effectively.
Is my FX strategy a success?
There is a strong case for benchmarks but, very importantly, they have to be realistic. A classic FX risk management error is to measure success by whether the hedge made money rather than if it protected profits.
There is also a consensus that a hedge is unsuccessful if the rate moves even further in your favour meaning you have a weaker rate locked in. There are ways around this such as drawing down early or only hedging a percentage of your currency for the year, but if the rate moves even more in your favour the hedge should still be considered a success. Not only have you protected our profits, but you also have more margin in hand.
Not having an FX strategy leaves businesses unprepared for volatile currency movements resulting in unexpected costs, lower profit margins, and limits to cash flow.
To find out how you can begin reducing the risk of exchange rate volatility speak to one of Currency UK’s foreign exchange experts by calling +44 (0) 20 7738 0777 or visit their website.
Author: Rob Affleck - Head of Corporate, Currency UK
Posted 4 August 2020