Strong companies will be well aware that avoiding risk is impossible; however, to be successful this must be mitigated. One example of this is the process of getting insurance against stock being destroyed or damaged. Key person cover is also often purchased to protect against an important executive or individual from being away from key business processes. Businesses also vary their stock to face the changing demands of each month or season such as Easter, Christmas or the summer holidays.
As a firm that works in more than one market, currency fluctuation is a huge risk issue for businesses and may be one of the greatest dangers in the working world. There only needs to be a tiny movement in the exchange rate and, as a result, you could be faced with a major price rise in imported supplies, or revenue you get from exports may collapse. You might even find that you can no longer afford to sell your wares at competitive prices in high-yield markets.
However, it is often dealt with if companies adjust their business accordingly, such as by re-pricing goods that do better with overseas buyers while making domestic wares a little more expensive to make up for the issue. However, other forms of exchange rate risk can be more serious.
Speaking hypothetically, if a British firm signs a deal to make machinery to export to North America for $1 million with payment on delivery, and the deal was signed in January 2011, the firm would expect the contract to be worth around £650,000. If it took four months to build and deliver the goods and fluctuations in the market fell out of favour with the manufacturer, they could receive less than £600,000. As tight margins often govern profits in today’s competitive market, this could effectively wipe out the profit on a deal.
Naturally, things can work out the other way round, too. If the aforementioned deal was struck in May 2011 and completed by October, the manufacturer would have seen a financial gain of a further £50,000 on top of the £650,000 originally expected. Of course, this unpredictability is a big problem: things may go your way, but you’re still gambling on the markets. This is not the best way to run a business!
Many companies resort to simple solutions, such as insisting on a completed deal at a fixed exchange rate or basically demanding payment in their domestic currency. This, however, is not realistic for many small and medium businesses as these enterprises cannot afford to play hardball when negotiating with bigger customers; smaller clients will just look elsewhere.
The best answer in this situation is to engage in currency risk management through forward exchanges. By making an agreement with a currency exchange firm, you can complete a currency exchange at a fixed rate on a chosen date. Here, it means the company may agree the rate when the machinery is ordered before simply converting the cash when the payment is received, doing away with the worry regarding prevailing market exchange rate fluctuations.
If you have more complex requirements, there are several tools that can tweak the deal. A limit order will allow you to set a desired rate, allowing the deal to go through automatically when the market rate reaches that level. Meanwhile, a stop loss order helps you set a minimum or maximum rate that a deal can go through automatically at, meaning you can be protected against a rate moving too far in the wrong direction.
Author: This article was made in conjunction with TorFX. For more information on currency exchange and EUR to USD forecasting, visit the euro dollar forecast from TorFX.