As technology makes it easier to forge relationships and source goods and services in far flung places, businesses of all sizes are increasingly operating in foreign markets. There is a whole world of partners, products, and new markets out there that could take your business to the next level. But whether you’re an established overseas operator or just beginning a venture into foreign markets, international opportunity comes with its own set of challenges, especially currency market volatility.
Cash flow is one of the biggest reasons why small businesses go under, and this risk increases in an environment where currency fluctuation is part of the mix.
Steven Dooley, Convera’s FX and Macro Strategist – Asia Pacific, explains, “Currency volatility can have both positive and negative impacts on a business.
“If an importer is buying a weakening currency, this can increase a company’s purchasing power, allowing it to purchase goods and services more cheaply. However, if the business’s home currency becomes weaker against the country where it sources or manufactures goods, the cost of those materials increases and must be absorbed by the business or passed on to customers.”
Fluctuating exchange rates can also lead to unexpected changes in revenues and expenses which makes it difficult to manage cash flow.
For example, if a business has sales denominated in a foreign currency and its home currency strengthens, the business will make less on each sale despite the amount of goods and services sold remaining the same.
Conversely, if the company’s home currency appreciates against a currency in which it needs to make payments, the business may experience an increase in cash flow as the value of its payables decreases.
All of this makes it difficult to accurately forecast and budget, which interferes with a business’s ability to plan for future investments, expansion, and growth. However, while no one can predict the movements of currency markets, the effects of volatility can be proactively mitigated. Here are five steps to managing your company’s exposure to currency risk.
Understand your exposures
No business can manage currency risk without understanding where its exposures exist, and what it currently does to protect itself from volatility (if anything).
Start by assessing your business goals and how they are impacted by currency exposures. Speak to a range of people in your business to get different perspectives on what is and isn’t working.
At this stage it can be beneficial to use a monitoring and analysis tool that evaluates your upcoming invoices against real-time exchange rates, to highlight where profits are exposed. Such a tool will also show the cost of these invoices in your local currency.
Develop a risk management strategy
With an understanding of your business objectives and a handle on the local currency cost of your foreign invoices, you have the power to start making informed decisions.
Define some goals specific to managing currency risk. This could include defining a target exchange rate to help achieve your desired margins or determining what percentage of a payment to protect from currency fluctuation.
Consider establishing a formal risk management policy to define processes and ensure key team members are accountable. This might sound time-consuming, but a strong, short document can be created easily–particularly with the assistance of a foreign exchange specialist.
Select the right currency hedging tools for your business
Hedging tools help a business lock in a fixed exchange rate for a future transaction and mitigate the impact of currency fluctuation on its objectives*. The common misconception is that currency hedging is a strategy for large corporates, however the diversity of available tools means that any business dealing with foreign currencies can manage their exposures. It’s important to remember that one size does not fit all, and what works for one business may not be the best choice for another.
Working with an FX specialist will help to identify the best tools for the individual requirements of your business. Most businesses use a combination of tools, which could include:
Forward contracts
A financial agreement between two parties that allows them to lock in an exchange rate for specific date in the future. This provides a business with certainty about the exchange rate it will receive or pay on a specific transaction. In turn this allows the business to manage its cash flow more accurately. Forward contracts are the most common hedging tool used by businesses.
FX options
A contract that offers the ability to lock in an exchange rate to protect against unfavourable currency shifts, but also maintain the flexibility to benefit from a positive spike in the market. FX options sometimes require the payment of an upfront premium.
Natural hedge This involves matching incoming payments against outgoing cash flows in the same currency to help reduce the amount of net exposure. Internal hedging isn’t always practical, however, because timing issues can replace currency risk with alternative forms of uncertainty.
Evaluate, analyse, and adapt
Currency fluctuation operates independently of business fundamentals such as forecasts and budgets. To keep plans on track it’s critical to monitor your FX strategy and adapt to new circumstances and market conditions.
Regularly monitor FX rates and market trends to identify potential risks. This will help your business make informed decisions about operations and strategies to mitigate the impact of currency volatility. Identifying shortfalls and building on successes is vital. You might want to formalize this refinement process by aligning reviews with financial reporting periods.
Build a relationship with FX specialists
Stay focused on your core business by establishing relationships with specialists that can support your FX risk strategy. Markets evolve rapidly and most businesses lack the resources to stay abreast of developments. Working with a specialist in the field will help ensure your business gets up-to-date analyses of currency movements, and support for building a risk strategy that’s right for your business.
* When selecting the right tool for your business it’s important to remember that derivative financial instruments may expose a business to risk if cover is no longer required. These types of financial instruments may be suitable if the business has a high level of understanding and accepts the risks associated with derivative financial instruments that involve foreign exchange and related markets. If your business is not confident about understanding derivative financial instruments, or foreign exchange and related markets, it is strongly suggested you seek independent advice before making the decision to use these instruments.
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