IN this column, I thought I would share with you the thoughts of one of my senior members of the team David Menaghan, international commercial manager based in Huddersfield, on managing foreign exchange risks.
We've seen how volatile currency markets were as we headed into the recession and it’s likely that the markets will be just as unpredictable following the welcome announcement that the recession is officially over.
Whether your business is importing or exporting, it is important to know the amount in sterling being paid or received when contracts are struck.
Remaining in the spot market does not give you any guarantees and – in some cases – currency losses may wipe out any profits in the underlying contract.
The impact that exchange rate fluctuations have on profitability will vary but it can be significant as we have seen within the last 12 months, where, for example, the US dollar has traded between 1.37 and 1.70 – a range of 26%.
Managing foreign exchange risk does not have to be complicated and HSBC advocate the use of a simple four-point plan:
l Understand your exposures – what impact would an adverse currency movement have on your profitability?
l Understand the alternatives – you can choose to buy or sell currency in the spot market. Whilst simple, you will not know how much sterling you will need to pay or receive on your currency until the day in question. This can be a high risk strategy as the rate may move significantly after you agree the price with your customer or supplier. You may lock in to a fixed rate by booking a forward contract. This provides certainty but you could suffer an opportunity loss if rates subsequently move in your favour and you have to transact at the forward rate.
An alternative is to use a currency option that will offer you the potential for upside benefit if rates move in your favour (like a spot deal), but will provide protection against adverse rate movements (like a forward contract). However, a premium may be payable.
l Develop a strategy – it may be best to adopt a portfolio approach, using a combination of spot, forward contracts and currency options. As an example, you may decide to transact 25% of your currency at spot, fix 25% with a forward contract and cover 50% with an option.
This way, if rates move in your favour, you will benefit on 75% of your exposure (spot and options) whilst if rates move against you, you are protected on 75% (forward contracts and options). This is a balanced approach that provides flexibility and avoids you paying a premium for all of your protection.
l Implement it – historically, currency markets have been extremely unpredictable. It makes sense therefore, once you have formulated a strategy, to implement it without delay and ensure your profits are protected.
For many businesses, the impact of exchange rate volatility can be significant. At HSBC we have a team of specialists available to advise you on developing an appropriate strategy for your business to mitigate some of those risks.
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