Sunday, April 18, 2021

What is currency risk, and what does it mean for businesses that operate in multiple countries?

There’s that old saying, ‘by failing to prepare, you are preparing to fail.’

This is a useful adage for the business world, because a failure to recognise risk to your operations can lead to disaster further down the line.

Take currency risk, for example. Many businesses rely on an international associate – whether that’s as part of your supply chain or production, in assets owned overseas, or even as an exporter yourself.

What happens when the currency exchange rates move against you – i.e. if the pound sterling weakens against the currency used in those international countries you have a stake in?

Worse still, what if there are currency changes in a number of international countries in which you operate?

It’s bad news, that’s for sure, and you only have to look at a currency risk example to see how your business could be negatively affected.

The good news is that there are methods to minimise your exposure to currency risk and hedge your position to mitigate its impact.

What is currency risk?

Let’s imagine that your company imports components from an international supplier. On the day that you sign the supply contract, the exchange rate is X – you know, or at least think you know, the cost of the order.

What happens when the contract is delivered and the time comes to settle the invoice, and the exchange rate has changed to Y. If the currency rate has changed in an adverse way, the cost of the supply chain has increased exponentially beyond you and your suppliers’ control.

Multiply this to scale or across multiple orders – and even for contracts penned with suppliers in numerous foreign nations – and you have a recipe for disaster if currency risk is not built into your financial planning.

How can firms minimise currency risk?

The good news is that there are some strategies that can be deployed that will minimise your currency risk.

You can open a bank account in the international countries. This would certainly help to minimise transaction costs associated with different currencies, and you can even hedge your financial risk by investing in ‘safe-haven’ currencies such as the Swiss franc or US dollar – they hold their value better than minor forex pairs or exotics, which gives you a store of capital that can be relied upon.

However, the most common method of mitigating risk is forward contracts.

A currency forward is an agreement signed on the day of a contract that essentially ‘locks in’ that exchange rate. While you can’t benefit from positive fluctuations that work in your favour, more crucially, you won’t be stung should currency changes go against you either.

The beauty of forward contracts is that they allow for accurate financial planning, as you can file your projections and costs without the fear of something unforeseen occurring.

What about when multiple countries are in the supply chain?

Even where you have multiple supply agreements in numerous different countries, the opportunity to open forward contracts still presents itself.

Indeed, this hedging strategy should be considered even more important in this scenario, as your exposure to risk is even greater.

Make sure that your business is considering the possibilities of forward contracts and currency risk hedging – it could make a huge difference to your bottom line.

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