If you regularly buy or sell goods overseas, you will already be familiar with the challenges and opportunities which trading using a foreign currency can create.
At its most basic, both the value of your goods and the value of the payment you receive for them (or vice versa) can vary depending on the exchange rate between your currency and the foreign one. For example, if a UK business is selling products to a US company, the payment they receive depends on the exchange rate between the USD and the GBP. Exchange rates can fluctuate rapidly and in some cases dramatically, leaving both vendor and purchaser with a significant difference between predicted and actual financial outcomes.
Exchange rates can be difficult to predict, being influenced by a large number of external variables which are beyond the control of the parties involved in the transaction. In such circumstances, a significant number of companies choose to hedge foreign exchange risks, setting up an agreement to define the rate of exchange to be used for a particular contract or series of contracts.
Most companies select from one of two different forms of hedging when it comes to regulating their international payments. In the first instance, the exchange rate to be used for the transaction may be stipulated as part of the agreement. This means that the contract will go ahead at the agreed rate regardless of how the currency exchange is performing. This type of agreement is known as a forward contract. Conversely, an exchange rate for business transfers may be agreed, but with the caveat that should the exchange rate become more favourable, the transaction will be completed at the better currency rate (so in line with the market); the exchange rate mentioned in the contract becomes the back-stop option actioned only if the market becomes unfavourable. This latter option ensures that business transfers work in favour of the organisation initiating the transaction.
The obvious advantage of hedging is the certainty it provides to both parties of achieving a satisfactory outcome to the transaction. By exercising control independently of the FX market, it is possible to promote a win-win outcome, which might be more difficult to achieve should the exchange rate fluctuate significantly. This helps to create a better working relationship and paves the way for future deals. Future planning becomes easier and helps to ameliorate some of the risks inherent in any international transaction. International payments often become much easier to manage once a suitable hedge is in place.
Once an exchange rate has been set for a deal, there is no room to enhance profit through a market fluctuation. For many companies, one of the attractions of buying goods from foreign economies is the ability to make a healthy profit by selling or buying at a favourable time. Removing the ability to do this successfully can make a significant impact on profits, particularly if hedging is used regularly as a method of controlling expenditure.
For some companies, regular hedging when the market is at odds with the rate used in the transaction can create an artificially competitive or non-competitive marketplace. Particularly if a foreign currency fluctuation is due to factors pertinent to the business, rather than more generic variables. Ignoring the trend can begin to set up an unsustainable dynamic that could lead to unprofitable and unrealistic trading.
The usefulness of hedging when it comes to international trading varies, depending on a number of factors. Anyone considering using a hedge ideally needs to obtain some independent financial advice from a hedging specialist. This individual or team should understand not only the concept of hedging and the generic pros and cons, but also the specific situation as it relates to the sector in which the business operates and the currencies involved. There are big differences between the volatility of each currency, which means that each situation where hedging is being considered should be evaluated on its own merits.
Used correctly, hedging has a valuable role to play in reducing risk, establishing a win-win outcome for a trading agreement and establishing sustainable parameters for future agreements. That said, there are costs involved in the procedure and the removal of the risk posed by foreign exchange volatility can work to the disadvantage of both parties, depending on what the exchange rate does. For the majority of businesses, the most successful outcome will be obtained by seeking the right advice from an experienced financial team who are able to give an informed opinion prior to moving forward.
At The Currency Account our team of specialists help our clients mitigate the risk associated with international transactions by developing precision risk management strategies, tailored to the individual objectives of each business. To find out more register your business for free.