Fluctuations in the value of currencies can have an impact on the profit margins of trading firms, and the smaller the firm the bigger the risk. Currency Solutions’ James Tinsley spoke to the Daily Update to explain how FX risk can affect exporters and importers, and to set out some of the strategies they can use to manage that risk.
Profit protection
Setting out the risks that can affect exporting firms, Tinsley says:
“If you have a business selling its goods in Europe, when the pound strengthens, [that firm’s] goods become more expensive. They may have to cut profit margins in order to stay competitive within their market.”
In this situation, companies can use a ‘fixed forward’ or a ‘flexible forward’, which means that you can ‘lock in’ a currency requirement for a certain period of time at a fixed rate. This means costs can be known in advance.
“For someone who’s exporting, especially if they’ve got 90-day payment terms, they might send out an invoice for €50,000, but in those 90 days there could be a 3–4% fluctuation in the exchange rate.
“If they get that wrong, there could a 4% loss of the profit margin just through FX – no fault of their own.”
Strategies
Invoice hedging is one way to deal with this difficulty, Tinsley explains. Under invoice hedging, when you take out a forward contract, you know the exact amount of sterling you’ll get back once you get paid. This removes FX risk from your business.
Other strategies include limit orders, he adds.
“These are similar. A limit order is where you put a pending trade into the market and say ‘I want to achieve this [particular] rate at which you’re buying or selling the currency’.”
Then, “it sits there, 24 hours, five days a week” while the FX markets are open. As soon as the market for the desired currency hits the desired rate, it gets “locked in” for a period of time, when the firm can buy or sell with that rate guaranteed.
“This means that companies can be a lot more dynamic with their currency purchasing. Instead of just saying ‘oh, the market’s here, I’ll just buy it now’ and being stuck with that rate, if you’ve got a bit of time to play with in terms of when you need to sell the currency back you can put a rate on maybe a percentage point higher or lower.
“It means you’re eking out those currency gains where available and hopefully putting a bit more profit into the business.”
How to choose
Rate alerts are another option. These are similar to limit orders, but amount to a notification when a certain rate becomes available rather than an agreement to lock it in.
Explaining the value of each strategy, Tinsley says that limit orders “work really well for businesses that have quite a lot of time to play with”. One firm he works with are comparatively cash-rich, and this gives them the freedom to put in several limit orders at different rates. This allows them to “get the dips of the market”, boosting their profits by 3–4%.
That is not an option for everybody, however, and Tinsley notes that fixed forwards and forward contracts are better for firms with smaller profit margins.
“If you’re dealing with margins in the three, four, five, even 10% range and you want to protect that, then forward contracts are really important to stop currency fluctuations taking away from your business.”
