Exchange fluctuations are avoidable
While many retailers only buy and sell in sterling, the effects of currency changes will be an issue for manufacturers and distributors and by extension, retailers too. Anyone watching the slide of sterling in the run-up to the Brexit vote last month will have seen import prices rise while exports became more competitive. So how does the currency process work and what can be done to fix a commercial exchange rate?
There are undoubtedly all manner of ways to complicate things and while there are as many variations on currency products as there are permutations on a lottery ticket, there are also some straight- forward steps that businesses can take to manage currency risk.
As business becomes increasingly global, especially where products are sourced for retail, the issues surrounding foreign exchange management become ever more pressing.
David Johnson, a Director of Halo Financial, a foreign exchange firm, says that a conversation about currency risk generally starts with minimising exposure and that gambling on exchange rates can be a recipe for disaster. “There are risk management tools which can be utilised” ” he says. “Anyone who claims to be able to pinpoint exactly where an exchange rate will be at a certain point in the future is deluded.” Johnson adds that a market with millions of participants which transacts $5.3tn a day is not something which can be forecast with any level of certainty.
For those that are entirely risk averse, as soon as they have an identifiable currency risk, they might choose to purchase all of their currency requirements. If cash f low allows, they may wish to do that and hold the proceeds of the contracts on currency accounts pending payment requests. They will have removed exchange rate variation from their planning and have the flexibility of cash at hand in the correct currency when they need it. Johnson says that if cash f low doesn’t allow for that and this is the more likely scenario, they can still cut all risk through the use of forward contracts which use today’s exchange rate upon which to put a contract in place while delaying the final settlement of that contract for up to two years. This generally requires a part payment / deposit initially but it aids cash flow by keeping the bulk of funds available as working capital. “The other advantage of forward contracts”, notes Johnson, “is that, if payment is required more urgently or if the payment needs to be delayed, the forward contract can be flexed to either draw down for early delivery or extend (roll over) to a late settlement date if necessary.” It appears that many companies find that forward contracts are the tool of choice for payment of invoices on 30, 60 or 90 day terms as they provide exchange rate certainty for the whole credit period. Forward contracts are also used where goods are received on consignment or where letters of credit are required.
A firm that wants to see if the exchange rate is moving in their favour, and who wants to wait to see if there is some advantage to be taken from that trend, should consider a stop loss order (SLO). “This device is placed into the foreign exchange market with a market maker to guarantee a minimum exchange rate. The order sits as a latent instruction but isn’t actioned until the market moves in such a
way as to trigger the order,” explains Johnson. He illustrates the point with an example: A distributor needs to buy US dollars and the current market exchange rate is $1.42 but the trend looks like it is heading higher, they may be tempted to wait for a better level. Obviously the ever-present risk is that the trend changes and the pound slumps through to $1.35, wiping out any profit. Let’s assume they cannot make a return on the contract unless they can achieve at least $1.40 or better. In these circumstances, they could place a SLO at $1.40 to guarantee that rate as the worst case scenario while leaving the opportunity to buy at higher levels if the pound continues to rally. Essentially, even if the pound collapsed, as soon as the sterling – US dollar exchange rate fell to $1.40, the order would be triggered and they will have bought their US dollars.
There is another alternative to the SLO – options. Johnson says these are used by many companies, especially where they have sizable requirements and/or long term projects. He cautions that they can be expensive because plain vanilla options, as the basic form is termed, require the payment of a non-refundable premium yet they serve the same basic purpose as an SLO. The flexibility in an option is in the right not to exercise the right to buy at the option level unless needed.
Automated orders can be used in another way. A limit order can be used to target an advantageous exchange rate which is above the current level. According to Johnson this works because the foreign exchange market doesn’t rest. Trading begins on Sunday night UK time and continues around the clock until the US markets close on Friday night. “One by-product of this is that some of the most volatile periods occur when individual markets are opening or closing. This volatility can be captured by placing automated limit orders at pre-determined exchange rates. As long as the market trades to the nominated level, the order will be filled.” Clearly firms need to plan ahead.
PLANNING, PLANNING AND PLANNING
To a large extent, planning is the key to every aspect of success in managing your currency needs. If you ask all of your questions in advance, dot all the i’s and cross all the t’s you will suffer fewer shocks and avoid nasty surprises.