Foreign Currency is, in essence, a result of economic conditions, a symptom instead of a contributing factor. It is a sum of factors including: –
- Monetary Policy
- Macroeconomic Factors
- Global events
The purpose of this post is not to describe in detail every facet of what makes currency fluctuate, nor do we advocate that we know when the currency rates are likely to increase or decrease in value.
Considering that highly trained treasurers, academics and bankers have invested significantly in predicting the currency exchange fluctuations, how is it so that countless organizations and peoples are swallowed by the revenue losses from currency dips?
In addition to that, we subscribe to the believe that: –
- Changes in exchange rates are largely unpredictable.
- Exchange rates can fluctuate significantly over time.
The fundamental motive of this post is to provide general methods for exporters, importers and freight forwarders can use to minimize the risk of holding a currency other than its own.
Broadly speaking, the majority of global logistics trade is financed by the US Dollar. While having a bulletproof legacy of being a stable currency housed by one of the most powerful nations in the world, the USD is still a victim of the ebb and flow of currency fluctuations.
Unless we revert back to currencies that are pegged to commodities that have actual value, such as gold, or unless the IMF has a sudden change of hearts and allow the use of Special Drawing Rights (SDR) as the go-to trade financing method, we sorely have to be accustomed to currency fluctuations.
In broad strokes, currency values do not retain is value over a long-term period. A loaf of bread 50 years ago costs $0.23 Dollars, now it is around $3.00 to $4.00 Dollars.
*Disclaimer: Max Freight Forwarders is a global logistics provider, all contents provided is for informational purposes only. Nothing contained in the blogpost constitutes a solicitation, recommendation, endorsement or offer of absolute advice.
Why Do We Manage Foreign Exchange Risks?
You might come to the conclusion that, if currency risks are exposing me to the downside monetary loss, it also opens the window of opportunity for an increase in currency value, ergo an increase in currency revenue.
While categorically true, the most prized asset of any business entity is not it’s roller-coaster-like revenue reports, but actually a stable revenue stream across time.
How to Manage Foreign Currency Risk for Exporters
Determine Currency Risk Exposure
Firstly, we need to ascertain the level of foreign exchange exposures.
Any entity that is sensitive to the fluctuations in the value of one or more currency that will influence the bottom-line profit is deemed to have some foreign currency risk exposure.
To ascertain your currency exposure, it’s helpful to look back at your previous purchase order records.
Say for example, that you are an American company that has a steady order from Germany, and all purchase orders are transacted with Euro Dollars.
Over the past 10 years, you noticed that the purchase order per year amounts to EUR 1,000,000. This consists of half of your international trade orders. While the rest of the global purchases are dealt in US Dollars.
Armed with this information, you conclude that the following year’s purchase order will also come up to EUR 1,000,000.
Your currency risk exposure would be EUR 1,000,000 that year.
Realistically, a business entity wouldn’t have such a simple business transaction. The basis of determining the risk exposure is, therefore, aggregating the sum total of transactions in foreign currencies and rely on those historical data as a base for the next year’s exposure forecast.
Of course, this model relies on the fact that your sales number, cost per goods sold, and selling price are all constant.
The source of raw materials obtained from is also a factor. Do take into account when purchasing raw materials with foreign currencies as well.
Understand your sector’s price elasticity
This macro-level understanding helps you predict how your customers behave in light of price variability.
In economic terms, price elasticity is the behavioral understanding of customer’s demand in light of an increase or decrease in price. Generally speaking, the higher the price of goods sold is, the lower the demand for the goods sold.
Therefore, determining how price elastic your goods are means determining how big a change in consumer demands is for an increase in price.
High price elasticity of goods means an increase in price will drastically drop the demand of goods sold, vis-à-vis low-price elasticity goods where an increase in price will affect the demand of goods less.
Utilize one of these currency risk mitigating methods
Speculators purchase financial derivatives for the potential profit. However, it can be used to mitigate downside risks. That said, a financial instrument used to hedge currency risks comes at a cost.
We reiterate that we did not attend the school of financial derivative wizardry, always seek a financial advisor to manage your company’s currency risks. Because if financial tools are wrongly applied, it can even aggravate your risk exposure.
The available currency derivatives are: –
Another point we need to push across is that risk management comes at a high cost, as those derivatives and its maintenance will be a constant operational cost, should you decide to use this method of risk mitigation.
Let’s look through the basics.
Going back to that example, you received a purchase order from Germany once again for 100,000 Euro. Since you have a long-standing relationship with your client, you granted a payment term of 60 days.
So, even though you have a receivable of 100,000 EUR, the actual cash will be wired to you 60 days from now, that exposes you to the risk that the EUR Dollar will devalue against USD 2 months later.
You wisely purchase a forward contract of EUR/USD 1.00 for 100,000 EUR, which means 1 USD in exchange for 1 EUR.
60 days have passed, coincidentally, the USD weakens against the EUR from 1.00 to 1.1, meaning 1.1 USD will only get you 1 EUR.
Now, without a forward contract in place, you stand to lose
(1.0 – 1.1) * 100,000 EUR = 20,000 USD
That is a 10% drop in potential revenue
However, with a forward contract at a rate of EUR/USD 1.00 for 100,000 EUR, you have pretty much guaranteed an income of 100,000 USD.
Mind you that even if the USD strengthens in relation to EUR, you will still need to exercise the forward contract regardless. You capped your potential currency gain.
Whether to buy a forward contract at the current spot rate or at a rate higher or lower is entirely speculative, and subject to your client’s agreement.
A forward contract is a bilateral agreement between the buyer and seller. Hence, it is often transacted between the exporter and importer. This is commonly referred to as an OTC purchase (Over-The-Counter)
Forwards and Futures contract are underlyingly similar, the only difference is that a futures contract is regulated and traded on an exchange.
Another aspect of the futures exchange is that it is necessary to post assets a form of collateral to qualify yourself to purchase futures.
There is no physical goods settlement involved when the contract is exercised, and a clearinghouse exists as a platform to buy or sell the currency futures. This poses some liquidity problems that you might want to avoid.
Therefore, many entities involved in import and export actually prefer to use a forward contract instead of a futures contract to hedge currency risks. But it is good to have options available.
Currency Options gives the purchaser the right, but not the obligation to trade the currency at a predetermined exchange rate.
In layman terms, if you have a currency option, you have a choice of exercising that option or instead let it lapse if the exercise rate is not favorable to you.
This is the primary difference between an Options and a Futures/Forwards, if you purchased a Future/Forward contract, you are obligated to exercise that contract. Whereas in an options contract you do not need to.
There are several key terms that you have to be accustomed to, here are the entrées for you to study further: –
- Put Option – Gives the holder the right to sell a currency at an agreed price.
- Call Option – Gives the holder the right to buy a currency at an agreed price.
- Strike Price – The pre-determined rate that the option is exercised with.
For example, you purchased a EUR/USD put option, an option to sell 1 EUR Dollar for 1 USD.
Before the expiry of the purchased call option, you have fulfilled the purchase order and received EUR 1,000,000 Dollars.
Upon receiving the money, you check on the current EUR/USD rates, it is at the rate of 0.8, or 0.8 USD in exchange for 1 EUR dollar. This is more expensive than your open call option, therefore you decide to exercise your option to sell 1 EUR in exchange for 1 USD, which was the predetermined strike price.
In contrast, if the EUR/USD rate is observed to be 1.2, 1 EUR in exchange for 1.2 USD. It is not attractive to exercise your put option as the EUR Dollar has strengthened against the USD. You choose not to exercise the put option and sell the EUR Dollar at the market rate of 1.2, with a handsome currency gain.
Price Currency Risk Into Your Products
You can choose to price your goods higher in order to compensate for potential currency fluctuation in the future. While not common in international trade business, this method can pose as an arbitrary and obscure way for shippers to increase goods sold.
This is why understanding the price elasticity of the goods sold is an important part of determining a method to manage foreign currency risks.
A product’s demand that is less sensitive to an increase in price sold will be more suitable to use this method. As the rule of economics, and logic dictates, that the higher the price of goods sold, the lower the demand for that goods.
Products that are price inelastic are products that are in the luxury segment. For example, a USD 30,000 increase in the price of a Ferrari will not sway a buyer from buying that Italian Stallion, but will definitely sway me, a mere mortal, from getting that Honda Civic.
Every product lay in the spectrum of price elasticity. Plot your product properly in that spectrum, if you are the lucky few that has a product exported that in price inelastic, you can increase your product price to account for potential currency fluctuation.
In the logistics sector, however, this is a common occurrence. The phrase the sector use for this charge is the “Currency Adjustment Factor” or CAF.
Ocean freights are made available for a typical exporter and importer prior to the booking confirmation.
From the time the ocean freight quote is confirmed and the cargo arriving at the destination port, factoring into consideration of the sea transit time, we are potentially looking at 2-3 weeks lag between the quoted price and when the shipper/importer pays for the ocean freight rate.
Therefore, shipping agents implemented an additional currency adjustment factor charge to take that into consideration.
Position Your Company to Have a Natural Hedge
Recall that we mention that it is important to understand our net currency exposure before strategizing a way to minimize currency risk? This will come in handy for this strategy.
Instead of focusing on the currency risk exposure from selling goods abroad in a foreign currency, we also need to be mindful of our purchases as well.
As an exporter, buying raw materials or semi-manufactured goods is part and parcel of your business. With the advent of global logistics, there are a lot of options to consider. The world is your market.
Diversification is key to this strategy, the more diverse your currency exposure is, the more stable the hedge will be. It is all attributed to the idea of statistical correlation.
Two highly correlated currencies will move together, both high and low. A negatively correlated currency will move opposite of each other.
As a guide, the CHF/USD currency pair is known to be negatively correlated, whereas the EUR/USD currency pair is known to be positively correlated.
With information such as this in mind, if it is economically feasible to import your manufacturing materials from Switzerland, you can then naturally hedge your exposure to EUR Dollars, by exposing yourself to another negatively correlated foreign currency with your local currency.
Foreign Currency Risks has to potential to pendulum-swing your company’s underlying profit, even in a perfect world where your customers are constantly purchasing your products, you can have 1 year of net profit gain, and another year of net loss.
Minimizing foreign currency risk requires active management and adjustment. But the key takeaway from this is, never to be overly exposed to foreign currency risk. A company’s stability is always a better indicator of future success.