When foreign exchange rates begin to wobble, it can cause a lot of worry for enterprises. Wouldn’t it be nice to know you can take your eye off the foreign exchange rate and know things will remain stable?
For any enterprise trading internationally, a sudden decline in the value of the pound is their worst nightmare. Unfortunately, we don’t need to look too far back to see a whole wealth of cases where currency fluctuations have ended up costing UK plc a lot of money on the international stage. Therefore, knowing how to protect yourself from the inequities of foreign exchange (Forex) becomes vital when trading around the world.
Understanding how an enterprise can come a cropper when faced with fluctuations in Forex rates is relatively straightforward but it’s still worth approaching an expert to really get your head around just how big an impact it can have. “Imagine the company is buying from America,” says Chris Redfern, business client dealer at foreign exchange expert Moneycorp. “You have to buy dollars to pay your suppliers and variations in exchange rates will impact upon how much you pay.”
He explains that the beginning of this year has seen a particularly severe devaluation of the pound to the dollar, with the latter falling from a rate of about 1.61 right down to approximately 1.48 by late last month. In layman’s terms this means an enterprise that had bought $161,000 at the beginning of the year would have secured it for £100,000; the same enterprise buying them now would have to pay £108,000. Obviously, this can have a huge impact on a business’s bottom line, particularly when it will not have budgeted around having to pay an additional £8,000 for the same quantity of stock. As Redfern explains: “Variations can have a huge impact on people’s costs if they haven’t protected themselves.”
As an example, this is relatively straightforward but, obviously, as one can tell by reading the daily news on global economics, the actual picture is far more blurred and much harder to preempt. Predicting what’s going to happen on the international markets is hard enough for Forex experts, so what hope do entrepreneurs have, particularly when they’re still overseeing every element of their business? Fortunately, there are some natty tools available that help protect businesses trading internationally.
What most enterprises want is to know that the rates they’ve budgeted around can be relied upon. “Generally, what happens is people start the year with a rate they’ve budgeted at, pricing everything they do on a certain exchange rate,” says Redfern. This means the key to protecting oneself is being able to fix that rate at that point; the most popular method is something called a forward contract. Essentially, a business strikes a contract with a firm like Moneycorp, agreeing to buy a set value of currency over a specified period at the current rate. The enterprise doesn’t have to pay ahead of time; they simply make a commitment to that amount of currency. He continues: “Then they would just say they’re going to pre-buy all of that currency and ask us to fix a rate for those dollars for the next 12 months, using them as they need them.”
As solutions go, it’s rather a neat one but, as with most things financial, it’s not quite as straightforward as it may appear on paper. One of the most obvious drawbacks is that businesses might not always know exactly how much currency they will need ahead of the time and entering a contract speculatively isn’t the most comfortable deal an entrepreneur can make. “In that case, you have two scenarios: you can have a guess at what you think you’re going to protect and then maybe just cover slightly less than that so you’re not overly committed,” says Redfern. “The other option is you do 50% protection for what you expect to need and leave the other 50% floating.” This allows an enterprise to hedge against fluctuations without committing themselves to currency deals that they may end up regretting.
But the real elephant in the room when discussing entering fixed Forex rates is, of course, that not every fluctuation in a currency will go against you. Many traders make huge profits on the Forex markets and this is because for every loss there is a gain. This means protecting yourself against negative fluctuations also means that you won’t benefit from the positive ones. The option that seems preferable will often depend on the sort of personality that is at the helm.
“Some entrepreneurs are gamblers by nature – they won’t hedge because if it gets better for them they’ll lose out,” explains Redfern. There are varying perspectives about forward contracts. Some individuals will see it as speculating and trying to profit from the changes in currency; others will see those opening themselves up to the profit and loss as being the true speculators. “You can make an argument either way,” says Redfern. However, he is quick to qualify this, saying that more often than not entrepreneurs will side with safety over risk. He explains: “The phrase I probably hear the most is, ‘I’m not in business to make money from currency; I just don’t want to lose anything’.”
Obviously, economic climate has a huge impact upon executives’ views on these forms of rate fixing. “A few years ago, at the start of the credit crisis, a lot of people had gotten a bit complacent,” says Redfern. The stability of the Eurozone, among other global economies, meant that people had begun to take their eye off exchange rates, assuming that they were relatively safe. The economic crisis that began in 2008 has brought variation currency rates firmly back into the public conscious. “All of a sudden it was a massive rude awakening and scared a lot of people,” he says. “Suddenly it became a priority. If you were a risk-taker, at that stage you could have easily gone out of business.”
Managing your Forex transactions responsibly can be the difference between your company surviving tough times or going belly up every time a bubble pops in an international market. Whether you want to play it safe or you want to keep yourself open to potential profits, it’s clear that you ignore Forex fluctuations at your peril.