Six ideas to overcome currency risk in your business. Once your business gets burnt by adverse currency move, you understand how vital it is to mitigate the risk and protect your business.
If you ever imported goods from China, you probably noticed that your expected earnings move up and down a lot during a few months between you make a purchase and the day when end clients pay you money.
For instance, you are in Berlin and you’re buying electronic items that you need for $145,000. The EUR/USD rate is 1.1850 today. So you need to sell €122,360 to buy required amount of dollars. You prepay 20% of the total on account and wait (so you still have $116,000 to complete the payment). After one month you will pay the rest. In the meantime, the EUR/USD exchange rate fell to 1.1650 USD. That means you need to exchange furter €99,570, to pay $116,000. If there hasn’t been a change in the exchange rate in the meantime, you would have needed only €97,890 – you would have save €1,680. I hope this shows how important part of any cross-border business is management of a currency exposure. It should not be a side activity – it’s part of your core business.
Forward is a fixed-price transaction that simply means that you are making a deal with a bank or your broker that you buy or sell amount of currency in one specific day at a fixed price, fixed at the time of making it deal. To walk you through the process, let’s go back to the example above:
As your Chinese partner wants you to pay the rest of the invoice when your purchase is on the ship, the best way to manage currency risk is to do a forward transaction on the day of a purchase. So during the first day you call your bank or broker and say that you want to have a fixed EUR/USD rate for the next two months. They quote you the rate – for instance, roughly the same for this currency pair as the interest rates for both EUR and USD and currently very low. So you make a deal that after two months you sell to the bank euros to receive $116,000 for 1.1850 USD. Whatever happens to the exchange rate after you made the forward, you don’t have to care. If the rate goes to 1.2000 USD, you won’t bbenefit. If the rate goes to 1.1500, you won’t lose. You know that your rate is exactly 1.1850 USD no matter what happens to the spot price. Therefore managing currency risk as in the example above will allow you to calculate your international margin precisely and therefore de-risk your business.
If you got a car, it’s required by law that you have a car insurance – it is compulsory. You have it, but you wish to never use it. You can compare this analogy to buying a currency option. Your rate is 1,1850 to buy dollars with euros. So currency option means that you open a contract where you have the right to execute the contract (in the opposite of forward transactions where you are obliged to execute the deal). Because, due to the nature of the option contract the execution is not compulsory you have to pay to acquire this right – pay a premium. To secure that level for this amount you would need apr. 3% of total hedged amount in premium.
How does it work ?
On day one you buy a put option that secure your EURUSD position. It costs you about $3,000 for the right to sell €99,570 with the rate at 1.1850 USD. You have been secured for the negative scenario – if the market goes down to 1.1650 USD from now. However, if the market goes up to 1.2200 USD level, you don’t use the right to execute currency option, you let it expire. You just call your bank or broker and sell EUR for 1.2200 USD in the spot market. It’s as simple as that !
Unfortunately, it works when your trading margin – the margin on the business deal is more than 5%. When it’s less, you use your trading margin to buy the option and earn nothing after the cost of currency hedging. On the other hand, if your trading margin is about 50% – don’t hesitate to check what possibilities are there for you to fix the margin and improve your financial planning.
There are also more complex currency options’ strategies that are composed of single options with varied expiry and strike levels. That’s the topic for the next article.
There is a wave of “Fintech” brokers that appeared in the market may offer you local currency, for example Indian rupees. It means that if you normally trade in dollars with some “far away” country, because everybody around also does so, you may ask your exotic business counterparty if he prefers his local currency instead of a dollar. Perhaps this could make his business more predictable and you could negotiate a better price from him?
If you are still uneasy about trying above-mentioned solutions you can always set the flexible price with your clients – linked to trade currency. It’s worth to have such a contract clause in your agreement. So if the rate moves more than for example 2-5% from the purchase day to the date of issuing the invoice, you have the right recalculate the price. For that, you need to have a strong negotiating position but it is probably worth asking. Anyway, it’s the best option for you – you secure your margin when the exchange rate goes wrong and raise your margin when the rate goes your way.
It’s similar to the above possibility. If you purchase in dollars from China, you ask your clients to pay you in dollars. Then they would say that they don’t operate dollars thus there is no way to do so thus you can set your price and have it indexed to the exchange rate. Thus they will pay euro, but the amount in euro depends on the rate included in the invoice. You ask them to pay you $116,000 USD, but ask them to pay you in euro with the rate of calculation 1.1850 USD. So then you have no risk. If your client also has a counterparty with someone who pays him in euro then it make clear sense for everyone here.
Managing Budgeting Rate
Last, but not the least is the solution to analyse your budgeting rate. Some companies that make long term contracts plan their business using the budgeting rate at the beginning of the year. They use it for all future calculations in that year. It’s worth to analyse your buys or sells in comparison to the budgeting rate. When the trade currency price is in time of volatile moves, do nothing until you still have your “currency security pillow”. The worst thing is to change the price for your client immediately. If you treat your currency differences between the budgeting rate and current market rate as a pillow and not as a speculation, then you can manage this very smartly and transfer your currency surplus into client promotion.
What to choose
Everything depends on your scale and power. If you are strong enough, change the price if currency rates is being changed. If you can’t, you can use forwards or currency options depending on your treasury limits and international trading margin. If you can, use local currency with low spreads. If your counterparty doesn’t want to pay currency, index your local currency price with the fixed rates. It’s also important to not use currency surplus for extra profit, but treat is as a future currency pillow.
Founder & CEO