A guide to foreign exchange

International trade can present businesses with new opportunities, but buying and selling goods in another country introduces additional risks. This section highlights some of those risks and introduces some of the steps your business could take to offset them.

Foreign currencies – the risks and how to mitigate them

With growth in non-Japan Asia growing by 9.5% in 2010, the three largest economies in Latin America by 7% and Brazil by 7.5%, (compared to the UK and Eurozone’s 1.7% and US 2.8%) it’s no surprise that an ever-growing number of UK businesses are looking beyond our shores. Such currency fluctuations can, of course, cause your costs to increase or your revenues to fall. The chart below demonstrates the extent to which the Pound has fluctuated against the US Dollar over the longer-term. For example, in July 2008 one GBP would buy over 2.00 USD. Within 6 months, by January 2009, one GBP was only worth little more than 1.35 USD – a huge change for any UK business with dollar exposure.

But it’s important for businesses to recognise the foreign exchange risks involved in dealing in any foreign currency, even the so-called ‘majors’. For example, recent global events have shown us that the Pound can fluctuate dramatically against more familiar currencies such as the Euro and US Dollar – and will likely continue to do so.

Managing foreign currency fluctuations

The good news is that your business doesn’t have to be exposed to currency risks like these, unless you take a conscious decision that you want to. You can work with your bank to help provide greater certainty for cash flow planning and budgeting, or a degree of protection against a critical level of exchange rates, beyond which profitability becomes threatened. We understand that no two businesses, or their attitudes towards foreign exchange risk, are the same – which means that flexibility and creativity are crucial in building an appropriate range of potential risk management solutions.

Example 1
Here we examine how currency risks affect a business. Take the example of a UK-based fashion wholesaler, arranging to sell the summer 2009 lines mid 2008.
They take orders at GBP list prices from their UK customers in July 2008 and enter into an agreement to buy the merchandise from various suppliers in China for a pre-agreed USD amount (say $500,000 in total) for payment on delivery in early 2009.
At the point of entering into the agreement with their Chinese suppliers in July 2008 at a GBPUSD exchange rate of 2.00, they would have expected to have to pay £250,000 for the finished goods. However, at the point of having to pay the invoice in January 2009, to buy $500,000 will cost them approximately £370,000.
It may not be possible for the wholesaler to pass all (or indeed any) of this increase on to their customers, meaning this almost 50% hike in their costs has a direct impact on their bottom line.
It’s no surprise that, with such a big potential impact on businesses’ bottom line, foreign exchange risk was highlighted by exporters as the number one risk concern in the The Economist Intelligence Unit’s (EIU) report titled ‘Risk Radar 2011 – How firms are navigating risk’.

Businesses should prepare themselves for a changing landscape in foreign exchange markets; one where businesses are dealing in more countries and in more currencies than they have in the past. Combined with the increasing economic and political uncertainty that can drive currency fluctuations, it’s likely to become ever more important that businesses work with a trusted and experienced partner to develop an integrated, relevant and flexible risk management strategy.

Example 2
In this example we look at how a business might mitigate foreign currency exchange risk. We’ll look at a UK based travel operator specialising in coach tours and holidays in the UK, with a European customer base (primarily Germany, France, Italy and Holland). Their income is in Euros and their costs in Pounds, putting them at risk if the Pound strengthens against the Euro (each Euro of income would cover fewer pence of cost).
With tight profit margins, the business cannot risk the exchange rate moving too far against them, so needs to guarantee a known ‘worst case’ rate at which they can exchange EUR for GBP. However, having experienced a weaker Pound against the Euro in recent years, they know the boost to their business that an even lower Pound to Euro exchange rate would provide.
The relative rigidity of a forward exchange contract wasn’t right for their business. Understanding their client’s industry and taking into account their attitude to risk, critical budget rates and other factors, the best solution was to use a combination of foreign exchange options and forwards – the most common building blocks of any foreign exchange strategy.
This approach to foreign exchange risk management gives them their ideal blend of protection and the potential to steal a march on their competitors, should exchange rates move in their favour.