Protect Against Currency Fluctuation

Sunday Business Post - Nov 19 2006

All businesses involved in international trade, both importers and exporters, have a responsibility to protect themselves from the potentially negative impacts of currency fluctuation.

‘‘Currency fluctuations can make a significant impact on a business’ profits,” said Niall Duggan, head of FX sales with Bank of Scotland Ireland.

‘‘For example, dollar exchange rates can typically move one per cent within a day. If you are in a low margin business, this can make a difference to your profit margins.

“Hedging your currency risk is something that most people, whether they are importing or exporting, should be doing as a matter of course.”

The two main options available to help businesses manage these risks are forward contracts and currency options.

Forward contract

‘‘The most important and most used is a forward contract, used for 98 per cent of all currency hedging,” said Paul Fleming, treasury specialist with Bank of Ireland Global Markets in Dublin. ‘‘It is the simplest product and there is no cost associated with it. If used in the way it is intended to be used it is a brilliant product.”

A forward contract allows a company to set the exact exchange rate they will pay on a transaction, even if this transaction is to be completed some time in the future. The cost to the customer is zero, and the bank agrees to take on all the currency fluctuation risk involved in the transaction.

For example, a company may export a product and agree to receive payment in three months time of $200,000. If the dollar/euro exchange rate is 1.25 per cent, they will receive €160,000.

However, if the rate has risen during the three months to 1.29 per cent the company, will receive €155,000.This could have a serious effect on the business’ bottom line.

With a forward contract, agreed with a treasury specialist, the company can set the rate at 1.25 per cent in advance.

They will receive the agreed sum of €160,000 in three months' time. The risk will have been passed on to the treasury specialist.

Of course, exchange rates can also move in the other direction.

Agreeing a forward contract removes any potential gain from the currency fluctuation for the exporter. However, Duggan argues that in the vast majority of situations, it is better for the exporter to take a step back.

‘‘A business is in business to make profit, from making widgets, for example. It knows that part of its activity very well.

“Foreign exchange is a different world, a different market, with many different factors affecting exchange rates. Most businesses can’t second guess the market. They are better off to stick to their knitting, so to speak,’’ said Duggan.

Currency option

Another package, aimed at protecting importers and exporters from currency fluctuation, is the currency option.

This is similar to a forward contract, however the customer now pays a fee to give them the opportunity to take advantage of any favourable movement in the exchange rate.

‘‘A currency option is almost identical to a forward contract, the only difference being that you can pay a premium on it for the ability to walk away from it. The reason you would walk away from it is that if in three months time the rate goes down to 1.21 you can deal at 1.21, but for that flexibility you pay a premium,” said Fleming.

Managing risk

Both the currency option and the forward contract are available in nearly every traded currency, and work equally well whether a company is primarily an importer, exporter, or both.

Knowing in advance how much you are going to receive in any business deal is a fundamental to most businesses; hence the popularity of the forward contract.

‘‘With a forward contract you have certainty. You know what a consignment is going to cost you in euro terms, so you can price outputs accordingly to achieve the profit margins you would like to achieve,” said Duggan.

It is possible for businesses to use currency fluctuations to their advantage, while simultaneously protecting themselves from any risk. One tactic is to purchase your hedge at the right time. Businesses can work closely with dealers to pick a favourable moment.

‘‘Clever customers are buying their cover opportunistically.

“If you look at exchange rates, they tend to move within ranges over periods of time, and clever customers would actually be buying their hedge at the optimum moment in the cycle,’’ said Duggan.

Fleming warned against individuals or businesses trying to be too clever by playing the market without the necessary knowledge or skills. Even qualified economists are unable to predict currency fluctuations with certainty.

‘‘The single most important thing that customers can do is to talk to their currency dealer.

“We can assess the risks that they have and then prescribe a solution. We try to look at each customer’s requirements separately and give them a more tailored solution,’’ said Fleming.