How do exchange rates affect business?
Currencies fluctuate against one another for all sorts of reasons. There may be high inflation in one country, low interest rates in another, or economic and political uncertainty. All the while, traders engage in round-the-clock speculation using different currencies (forex trading).
In the business world, these fluctuations have the biggest impact on companies that import and export.
Let's say you run a company based in the United Kingdom, and the value of the British Pound increases. Since the pound is stronger, imports become cheaper – you can buy more foreign products per pound. Conversely, products made in the UK are now more expensive than they used to be, both for domestic and foreign consumers.
The result is that local companies have a harder time competing against cheap imports – the British domestic market suffers.
If the value of the pound decreases, the opposite occurs. Products made in the UK become cheaper (and thus more attractive) to those outside the country. In this case, British companies should look into exporting abroad, where they may be able to make a nice profit.
So, thanks in part to regular exchange rate fluctuations, international business can be very lucrative. When things move in an unfavourable direction, though, exchange rate fluctuations can also lose you money. The risk here is known as foreign exchange (or FX) risk, and is an expected part of doing business internationally.
What are the different types of FX risk?
There are three main types of FX risk: transaction, translation, and economic. Let's take a look at each.
Transaction risk
Transaction risk occurs whenever you agree to make a transaction using a foreign currency.
Imagine you buy some product from a Dutch company for €10,000. On the day you sign the contract, €1 is worth £0.83, so €10,000 equals £8,300.
Of course, you're only going to pay once the goods arrive. After a few weeks, they appear as expected and in good condition. But there's a problem – over those few weeks, the pound has lost value against the euro. Now €1 is worth £0.90.
You're still committed to pay €10,000 to your Dutch supplier. However, since the value of the pound has declined, you have to pay more than expected – £9,000 instead of £8,300.
The purchase ends up costing £700 more than you thought it would. That loss alone isn't huge, but these amounts can really add up if you're importing products regularly.
Translation risk
Translation risk affects companies with subsidiaries in other countries.
Let's say there's an American company with a subsidiary in China. When this subsidiary reports its finances, they'll be doing so in the local currency: Chinese Yuan. Maybe they've had a good quarter, and increased sales by 15%. Great!
The problem is, over the past quarter, the value of the yuan has decreased significantly in comparison to the dollar.
So, when the company converts the number reported from yuan to dollars, it could show a diminished return – or even a loss.
This number will end up as part of the consolidated financial statement. It could even result in a fall in stock price as investors lose confidence in the company based on perceived poor performance.
In other words, translation risk distorts a company's financial situation.
Economic risk
Economic risks are long-term risks to do with large, macroeconomic changes in the market.
For example, maybe you move your manufacturing operations to China to take advantage of lower costs there – it's a common story.
But what if, over the next 10 years, the yuan becomes much stronger? The benefit of having moved your operations evaporates.
What can I do to mitigate FX risk?
How do you protect your business against these shifting exchange rates? Well, one way to do so – and potentially save a significant amount of money – is through hedging.
Hedging typically involves the use of financial instruments like forward exchange contracts or currency options.
Forward exchange contracts
Forward exchange contracts (FECs) are agreements made with a third party (such as a bank) to buy or sell a specific amount of money on a specific future date.
The benefit here is that you "lock in" the exchange rate that exists on the day you sign the contract (the spot rate).
Remember the hypothetical situation above, where you bought some product from a Dutch company and ended up spending £700 more than you thought you would?
By selling a set amount of pounds – as stipulated by the FEC – you'd be able to recoup that loss, or even make a bit of a profit.
Forward exchange contracts are an excellent hedge in corporate currency exchange because they allow you to plan far in advance. For instance, when trading one of the four major currency pairs (British Pound/US Dollar, Euro/US Dollar, Japanese Yen/US Dollar, and Swiss Franc/US Dollar), you can sign these contracts for up to 10 years.
If not trading one of the major pairs, FECs can last as long as 12 months.
Currency options
Currency options are like forward contracts in that they "lock in" the spot rate. The difference is that, whereas signing an FEC requires you to buy or sell on the agreed-upon date, currency options give you a choice.
So, if you're selling something in Italy, and the value of the euro takes a nosedive right before you get paid, you'd want to exercise that option and sell off your euros at the older, higher exchange rate.
Conversely, if the value of the euro against the pound suddenly skyrockets, you'd want to sell them at this higher rate.
The problem with using financial instruments like contracts and options to hedge out currency risk is that it can get expensive. You need to pay premiums to purchase them, and the more you trade internationally the higher the costs become.
However, there is another way to manage your foreign exchange risk, and that is by using the natural cashflow of your business.
What is natural hedging?
You don't always need to use financial instruments to hedge.
What if you could funnel those euros (or any other currency) back into your business without having to exchange them? This would constitute a natural hedge.
For instance, if you sell €5,000 of product in Italy, why not use that €5,000 to pay your supplier in the Netherlands?
To do this, set up a foreign currency bank account. Keep in mind that while you'll eliminate transaction risk for that specific currency, you'll still have to worry about translation risk when you convert profits and losses back into your native currency.
The challenge here is managing multiple currency accounts. If you operate across 10 different currencies, you don’t want to have to deal with 10 different banks. What drives us at 3S Money is making this process easier for global business owners.
Other approaches
It’s worth remembering that hedging isn’t your only option. After all, it's impossible to hedge against all risk.
When doing business internationally, it helps to take a wider view – you have the entire world to look at! There might be a country you haven't considered that has a more favourable exchange rate, for instance.
If possible, diversify where you do business. This can help things balance out. For example, the exchange rate from pounds to yuan might move favourably while the rate from pounds to euros moves unfavourably, so profits in China cancel out your losses in Europe.
It's also possible to put foreign exchange clauses into contracts with suppliers so you're guaranteed not to lose too much money if exchange rates fluctuate wildly.
A simple way to neutralise foreign exchange risk is by using only your native currency – this passes on all risk to the customer or supplier. However, this may make your business less attractive than other companies who are willing to trade in the local currency.
This option is best for online-only businesses since, if you have a physical location in the country, you'll have to pay taxes and (if you have employees) salaries in the domestic currency.
Overall, when it comes to FX risk, the trick is to be proactive, not reactive – plan ahead!
Create a 3S Money International Business Account
One of the best ways to be proactive and take advantage of fluctuating exchange rates is to set up an online, international business account to manage multiple currencies.
A 3S Money International Business Account allows you to hold and exchange more than 65 different currencies while doing business in over 190 countries, and manage it all on a single dashboard.
Think about your local bank. First, you'd first have to convert foreign money into your local currency before depositing it and, if you were to ask the staff there "How long does it take to exchange currency?", the answer may be as long as a week.
A 3S Money account allows you to convert currencies much faster, all without incurring the large fees typical of banks. Easy global money transfer makes managing your international business much simpler, and a clear view of current FX rates can help you prepare for changes in the market.