By Ryan Meredith
Managing FX risk effectively when international politics is increasing volatility
If your trade spans across borders, you will know only too well how the volatility of the pound can affect your bottom line.
Let's face it, you are great at what you do! You have built a successful business off the back of your unique knowledge and skill set. For most of us, this does not extend to foreign currency trading!!
The key is not to panic, but to take precautionary steps to manage foreign exchange risk. This should be a policy decision that is rolled out across the business as a whole.
There are five key ways that foreign exchange risk can be managed in accordance with your company’s risk strategy.
1. Fixing invoices in the domestic currency
The simplest method would be to fix your sales/supplier invoicing in (£) sterling. This removes the risk that the pound will weaken against foreign currencies. Taking this approach will also mean that the company will not benefit in times where the pound has strengthened.
Fixing the domestic currency will push the currency risk onto your customer or supplier. This may not be acceptable to them. However, if they trade in the UK, holding UK funds, they may be happy to negotiate terms in sterling.
2. Foreign currency bank accounts
If you have transactions that result in income from customers and payments to suppliers, holding an account in the foreign currency is a great way to match income and expenses to mitigate the exchange rate fluctuations.
3. Forwards exchange contracts
These are contracts which are established to lock in an exchange rate today to match to the transaction at a future point in time. If a gain is made in the real world, this is likely to match the loss on the contract and therefore the desired rate has been artificially fixed.
If the transaction date does not match the contract date, there will be some foreign exchange exposure between the date of the expected receipt or payment and the date the contract ceases.
Using this hedging strategy will remove the downside risk of foreign currency fluctuations, however, you will not be able to benefit or capitalise on any favorable foreign exchange movements.
4. Foreign currency options
An option works in a very similar way to that of a forward contract. However, you can choose to exercise the option or not. If there is a favorable exchange movement for the business, the business can decide not to exercise the option and instead benefit from the exchange rate movement.
If the movement is not favorable for the business, the option would be exercised and the potential loss on exchange would be reduced or “hedged”.
Unlike a forward contract, to have the increased flexibility or the “option” a premium must be paid upfront and is paid whether or not the option is exercised.
5. Take the risk
As accountants, you will not be surprised to hear this is an option that we are unlikely to advocate! However, using this option depends on how large the perceived risk foreign currency presents to the business.
We strongly suggest talking to us if you are concerned or would like to complete a risk assessment in relation to foreign currency risks.