This guide will help you to save money on your foreign exchange operations (and the worry of FX volatility risk). In this guide (3 minute read):
- Foreign exchange hedging basics explained
- Why it is no longer complex and costly for SMEs
- Revealed: The 3 essential hedging products to propel your company’s FX strategy
On a £10,000 transaction for a UK company, the average FX fee with a bank is 3.6%, or £360. With a non-bank alternative, the average is 0.9%, or £90.
SMEs, as these figures show, pay much more in foreign exchange costs than what is necessary. And this high cost in fees understandably turns many SMEs off from pursuing a foreign exchange hedging strategy, as the general belief is that hedging products are expensive.
The main issue stems from a simple lack of awareness of the alternative options out there, which will help more SMEs to reduce their FX fees and volatility risk.
Your company can almost certainly save much more and maximise profits when it comes to foreign currencies. Without much hassle to boot.
But isn’t foreign exchange hedging complex and expensive?!
Foreign exchange hedging for business does indeed have a reputation for being complicated and expensive. This is largely because of the complicated and expensive processes traditionally offered by the banking sector.
The banking sector however has real competition for the first time essentially (unless you count a small group of banks offering the same thing for the same price give or take as a competitive market).
This competition has arrived in the form of companies who offer a service built on financial technology (read the Financial Times’ Martin Wolf on why financial technology is changing the finance sector for good here).
When it comes to company currency management, financial technology, or fintech to give it its more common name, has made foreign exchange hedging simple and much more affordable.
Why is foreign exchange hedging so important to your business?
Currency prices are inherently volatile. A currency’s price relative to another currency depends on so many factors that they will always fluctuate. These factors include interest rate levels; strength (or weakness) of economic data such as jobs reports; political stability; inflation; central bank decisions; and many more.
And in recent years, major currencies have been incredibly volatile, with wildly differing exchange rate levels. The pound shot down to 1.38 in January 2016 against the dollar and is now forecast to end the year at around 1.47 or 1.48, whereas the euro has fluctuated consistently between 1.05 and 1.10.
Does your organisation import or export? If so, this type of volatility clearly has a massive impact on your cash flow. If your profit margins are dependent on a specific minimum target exchange rate and volatility pushes it below that level, your company will take a hit due to foreign exchange fluctuation.
Even if it doesn’t, and you trade above your minimum rate, are you optimising your processes whereby you maximise profits and minimise FX loss? It is estimated that over 50% of SMEs with operations in other currencies do not hedge their FX risk, usually through a lack of knowhow, and a belief that it is difficult to understand and costly, as mentioned above.
The good news is that it doesn’t have to be either. There are foreign exchange service providers who are both expensive and their hedging products may be convoluted, but there are alternative options that are clear and will save you in costs.
Read this to get the essentials on how to hedge foreign exchange risk for your company easily
As discussed above, the need to hedge your risk if you have exposure to other currencies is evident. Failing to hedge this risk is poor practice and puts your company’s financial health in danger.
1 – The humble forward contract explained
A forward contract allows you to lock in the exchange rate of the day for a set date in future, usually up to 12 months. This offsets the risk of the exchange rate moving unfavourably for you in the intervening period. Handy for ensuring you don’t have to pay more for future payments down the line.
You might be thinking, “Yes, true, but there is also the chance of the exchange rate moving in my favour”. And you’d be right, but this is essentially a form of speculation, akin to a currency day trader. If you want to bet with your company’s money on exchange rate movements, by all means, go ahead. We don’t recommend you do however.
A forward contract is simple and non-expensive and guarantees a sure method of effective foreign exchange risk protection.
Banks and brokers have many more complex versions of the forward contract, but they are often so layered that even the largest of multinational companies don’t need them.
A basic forward is inexpensive, consisting of the spot exchange rate plus the interest rate differential between the two currencies for the period indicated in the forward contract.
2. The open forward contract explained
Number one mentioned the forward contract, which is also a “closed contract”. Closed in this case means that the date in the future at which you want to lock in today’s exchange rate is immovable. This is particularly useful if you know you have to pay for an order form a foreign supplier on a specific date, in three months from placing the order, for instance.
But, what if you have multiple payments to make over the next six or 12 months, or longer? And you want to take the stress off of a fluctuating exchange rate? You want to lock down today’s rate on say, GBPUSD, to pay your Chinese supplier in dollars on a monthly basis.
This is where an open forward contract comes in. The key difference between an open and a closed contract is that with the open forward contract, you can draw down on the total amount you have agreed to in the open forward contract with your foreign exchange service provider.
So let’s say you make 12 monthly payments of $50,000. You can set up a 12-month open forward contract for $600,000 which guarantees you today’s rate locked in for the next 12 months. Then each month you can draw down $50,000 on this total in order to pay your Chinese supplier in US dollars.
3 – The currency options contract explained
In the same way that an open forward contract gives you a greater degree of flexibility than the closed version, an options contract goes another step further in granting you even more flexibility.
Whereas with a forward contract, you are obligated to meet the terms of the contract by paying the amount agreed to, an options contract is different. It gives you the right but crucially not the obligation to buy or sell the foreign currency at the exchange rate, during the time period specified.
An options contract is a formidable product in your hedging arsenal. It grants you the freedom to decide to transact at the going spot exchange rate, or if it is not favourable, you can draw down on your options contract.
The final Word
With these three currency hedging products your company will be primed for minimising FX risk and maximising your profits made abroad. And really, we can’t stress enough how straight forward hedging foreign exchange risk for your business really is now, and how key it is to your operations abroad.
Remember that these products really are as simple as they are explained above and now with the advent of financial technology foreign exchange, costs are no longer necessarily prohibitive as they have been with the traditional banking sector for so long.
Lastly, having an international payments and currency provider that can provide insider expertise with your best interest at heart – saving your company money and eliminating your volatility risk, not seeing how much profit can be gleaned from your company – will go a long way.
Foreign Exchange for Business – Eiger FX
Check out our most popular articles for your company:
2 – 4 Reasons Why Brexit Definitely Will Not Happen
3 – The Ultimate Business FX Management Cheatsheet In 10 Steps
4 – SMEs, This Is How Fintech Works – All You Need To Know
5 – Understanding Alternative Finance For Your Business