For businesses involved with imports or exports, or who often deal in foreign currency settlement, exchange rate fluctuations can have a big impact on business. Those involved in Pound transfers have likely seen Brexit increasing their currency risk. For SMEs, exchange rate volatility can be dangerous. One strategy to protect businesses against fluctuations and secure their cash flow is currency hedging.
What is currency and exchange risk?
This is the risk of changes in the values of different currencies, which can affect your business’s revenue, costs, cash flow and profits. Having an understanding of where and how currency fluctuations affect your business is key to mitigate this risk. Take a look at the following scenarios.
Your business is purely local
You source all your products in one country, all your offices and employees are in that same country and you have no international customers. In this case, you probably don’t have any currency risk. All your revenue is earned in one currency and all your costs are in the same currency. This means that exchange rate volatility will have little or no impact on your business.
You’re an importer
Let’s say your business is based in the UK and you sell only to customers based in the UK. This means that all your revenue is earned in Pounds. However, you also import some of your goods from the US, so a lot of your costs are in US Dollars.
If the value of the Pound were to drop by 10% against the Dollar, this would make the cost of your goods go up by 10%. For businesses with tight margins, this could mean the difference between making a profit or a loss.
You’re an exporter
In this situation, your goods are manufactured in the UK and sold in the US. This means that your costs are incurred in Pounds, but some of your revenue is earned in Dollars. If the Pound strengthens against the Dollar, the revenue you earn in Dollars is going to be worth much less. This is problematic because your costs remain the same.
How currency hedging protects your business from unnecessary losses
To use currency hedging you must set up a financial instrument that protects your business from unexpected, expected or anticipated events that result in fluctuating currency exchange rates — such as Brexit. Hedging can be likened to an insurance policy. It mitigates risk and ensures a steady and predictable cash flow – something that is vital when running any kind of business.
Fluctuations in exchange rates can affect your business, but what can you do about it? Here are six hedging strategies that can be used by individuals and businesses to manage their currency risk.
1. Forward contracts
A forward contract is a non-standardised contract or agreement set up between two parties to buy or sell a currency at a specified future time, at a price agreed upon at the time of contract initiation. This protects the buyer and the seller from currency movements because you are no longer tied to current exchange rates. Knowing that your prices are fixed will help you plan without worrying about how the exchange rate moves in the interim.
2. Currency options
A currency option is a contract that gives the buyer the right, but not the obligation, to buy or sell a certain currency at a specified exchange rate on or before a specified date. For this right, a premium is paid to the seller. The buyer decides which currency he/she would like to exchange for another and which date this conversion needs to take place. The buyer then sets the exchange rate he/she is willing to accept. The price for the contract, called the premium, is then paid to the seller to purchase the contract.
3. Limit orders
A limit order provides an upside price target. You set a price target above where the market is currently trading and when the market hits your desired price, your order is automatically filled. A limit order ensures that you don’t miss the opportunity to take advantage of your targeted price.
4. Stop-loss orders
A stop-loss order protects you against a weakening exchange rate. It allows you to set a "worst case" price to trade at below the current market level. Your order will be filled if the market drops to (or beyond) your protective price.
5. OCO orders
An OCO order, or One Cancels the Other, combines a stop-loss order with a limit order, allowing you to set an upper and lower price range. The moment that your upper or lower price target is hit, your order will be filled at that price and the other price target is immediately cancelled.
6. Dollar-cost averaging
Dollar-cost averaging is a hedging strategy that neutralises short-term volatility in currency markets by allowing you to invest a specific amount over a predetermined period. For example, if you have a $100,000 obligation, you could consider breaking this up into five separate purchases over the next month. This way, you minimise the risk from market fluctuations by locking in your full transaction amount in one trade.
Here's a quick summary of the different hedging strategies.
What it does
A non-standardised contract that protects the buyer and the seller from currency movements.
A contract that allows the buyer to buy or sell a certain currency at a specified exchange rate on or before a specified date.
Buy or sell at specified price or better.
Set a fixed price at which to trade and limit your loss against a weakening exchange rate.
Combines a stop-loss order with a limit order, allowing you to set an upper and lower price range.
Reduce short-term volatility by making regular incremental payments over a period of time as opposed to a one-off lump sum investment.
See also: But, do you know your broker’s name?
Find a forex partner you can trust
There are many forex providers who hook clients into using their services by offering amazing rates at the start, only to widen it overtime. We believe in complete transparency, so the rate you see is always the rate you get. We never surprise you with hidden bank charges. Our hedging specialists and forex brokers are always on hand to assist you with whatever query you may have.
We specialise in helping businesses develop strategies to manage their currency risks. We can conduct a free assessment of your currency management processes and facilities. Get in touch with us on email@example.com or give us a call on +44 (0) 20 7759 7554.
We are a professional services company that specialises in cross-border financial and immigration advice and solutions.
Our teams in the UK, South Africa and Australia can ensure that when you decide to move overseas, invest offshore or expand your business internationally, you'll do so with the backing of experienced local experts.