A beneficial, differentiated product and a sound business model will set up your business for success in domestic markets. But fierce competition or an oversaturated playing field can force firms to look for greener pastures with global audiences. Going global is not all smooth sailing, and there are particular challenges for companies that import or export goods internationally, especially when it comes to foreign exchange exposure.
Foreign exchange exposure falls into the following three categories:
- transactional exposure
- economic exposure
- translation exposure.
Our hedging strategy guide is designed to help businesses lower their currency exchange risks, improve cash flow management and guard against profit erosion in an ever-changing global marketplace.
Examples of foreign exchange exposure
- A Canadian oil company relies on overseas equipment manufacturers to supply parts for its oil extraction machinery. It agrees with a Chinese equipment manufacturer to purchase ten system components within a 60-day period. The oil company pays the Chinese equipment manufacturer in a foreign currency, the Chinese yuan. If the Chinese yuan loses value relative to the Canadian dollar, then the Canadian oil company will pay less for its imported parts. In contrast, an appreciating Chinese yuan will cause the oil company to pay more for its imported goods. That’s a simple example of transactional foreign exchange exposure.
- Britons love the delicious taste of Grade A maple syrup, but they have limited land upon which to cultivate enough sugar maple trees to meet the country’s demand. So a Canadian firm that produces premium-grade maple syrup cuts a deal to supply a few UK stores with its products. The Canadian company agrees to receive payment for its syrup in British pound sterling to gain access to the UK market. Sales soar, and so does demand for the company’s maple syrup across other regions in the United Kingdom. Today, the UK stores make up 85 percent of the Canadian company’s maple syrup sales. The Canadian maple syrup producer is now subject to longer-term foreign exchange vulnerability – economic exposure – as its cash flow and profits are impacted every time the British pound sterling dramatically fluctuates in price.
- A Toronto smartphone manufacturer sells its phones in 10 countries across three continents. To tighten its supply chain operations, the company decided to assemble its products in five countries via subsidiaries nearer to its overseas customers. The subsidiaries process transactions using a couple of foreign currencies. Subsequently, the parent company is subject to translation foreign exchange exposure because it must account for gains or losses of overseas subsidiaries on financial based upon domestic currency terms.
Foreign currency exchange volatility
In these three examples, the businesses are all subject to foreign currency exchange volatility and have to take foreign currency conversion rates into consideration. When the exchange rates for various currencies fluctuate significantly, they are said to have high foreign exchange volatility, which is directly related to risk. Understanding patterns in currency exchange rate changes, and implementing hedging strategies to mitigate associated risks, can save businesses money and help them to remain competitive in the long term.
Currency fluctuations that impact the global economy
Global market supply and demand sets the world’s currency values. It works in much the same way that free-market economies determine prices for goods and services. If a currency is in high demand, the price for it tends to go up.
The currency will also be worth more if there is a short supply in circulation. On the other hand, governments that flood the market with large amounts of their currencies find that the value of their money decreases. Currency price fluctuations relate directly to how much money flows into and out of the country of origin.
Some common causes of currency fluctuations include the following:
- geopolitical instability
- trade climate
- national debt
- interest rates.
A country’s currency value is often used to judge the nation’s economic health. While the West is usually looked upon as a model for economic development and wealth, Middle Eastern countries such as Kuwait, Oman, and Bahrain have produced the world’s strongest currencies in recent years.
The U.S. dollar has remained weakened due to low interest rates, high national debt and threats of a stricter environment for free trade. Under normal conditions, higher interest rates cause a nation’s currency value to rise, because foreign investors are attracted to the higher yields linked to those loans.
The UK’s pound sterling also took a slight dip in value after the Brexit vote. Demand for the pound decreased as investors believed that the UK would receive more unfavorable terms from their main trading partners in Europe.
Risk Management Mindset for Foreign Currency Exchange
Deciding to go into business is full of risks as well as opportunities, which are usually discovered by reading patterns in the economic environment. Implementing hedging strategies allows companies to manage their cash better so that they can take advantage of opportunities when they arise.
Even the most junior company employee knows not to leave money on the table – this is what any company does when it ignores foreign exchange exposure risks. Both the transaction that costs extra money and the transaction that might have earned additional profits equate to money left on the table. Foreign exchange specialists help SMEs to establish currency risk-management strategies, based upon their clients’ unique business activities and monetary transactions.
Foreign currency exchange risk-management tools
No currency risk management strategy is complete without considering hedging instruments such as forward contracts, options, and market orders. Forward contracts help companies to reduce uncertainty by locking in an exchange rate that they can use at a future date. Business parties can make these contracts stringent with a fixed date for use, or flexible with an open agreement. Typical forward contracts use exchange rates that are frozen for up to two years. If a business uses forward contracts to lock in exchange rates for two years, the company is obligated to buy the currency at the agreed-upon rate, even if the currency fluctuates in its favour a year into the contract.
Businesses that want the security of the fixed rate and the flexibility to take advantage of any positive currency movements should carefully examine the use of options. These organisations pay premiums to exercise a range of options, so the extent of their use is often chosen with care, at the advice of a foreign exchange specialist.
Companies can take advantage of movements in the market through two types of market orders – limit orders and stop-loss orders. Businesses can wait to buy a currency once it reaches a specific target rate by using limit orders. Stop-loss orders allow them to limit financial loss to a pre-set price point. Market orders, unconstrained by usual trading hours, are executable at any time.
Global markets are subject to quick fluctuations, and the reasons for those changes are not always straightforward. This level of complexity calls for in-depth analysis when choosing the right hedging tools for a currency risk management strategy. While this hedging strategy guide isn’t meant to address every risk scenario, it can give individuals and business owners an idea of which tools are commonly used to mitigate foreign exchange exposure.
In the case of the Canadian oil company that experienced transactional foreign exchange exposure with the Chinese yuan, forward contracts could help mitigate the risk of financial loss. For example, the Canadian company is set to pay the Chinese company 489,780 yuan in 60 days for 10 system components. The Canadian company, to hedge against losses, can buy 489,780 from a foreign exchange provider at a rate of 4.90 Chinese yuan to 1 Canadian dollar with a forward exchange contract that is due at the end of 60 days.
By doing this, the Canadian firm’s price for its ten parts is guaranteed to be no more than $100,000 Canadian, which is a reasonable amount for those oil extraction equipment components. For longer-term foreign exchange exposure, currency specialists recommend more complex hedging tactics such as currency swaps, outside of the scope of this guide.
Small business owners can learn lessons from the mistakes of the big, multinational firms that regularly employ hedging strategies. For instance, the CEO of Procter & Gamble mentioned that a stronger U.S. dollar could cause losses to its operations back in 2015, and he was right.
These types of losses occur when companies try to over-hedge their foreign exchange risks. They overestimate their future sales and hedge according to those inflated sales numbers. Forex analysts suggest that a company should only hedge for the minimum payment amount that is known for a future sale.
For more advice on smart strategies to manage cash flow and protect profits by mitigating foreign exchange exposure risks, consult a local currency specialist at a bank, investment firm or foreign exchange provider.
Four Business Solutions
Four Business Solutions helps small and multi-national organisations enrich the way they work. From supply chain to procurement and contract management, we have decades of experience helping companies forge ahead in the global market. If you’d like to find out more please call John O’Brien at Four Business Solutions on 0800 6250 025.
John O’Brien is the CEO at Four Business Solutions, global business consultants and software integrators providing business processes improvements in Finance, Supply Chain & Operations, across a broad range of industries.