Different foreign exchange risks

Foreign Exchange Risks - The very basics

Posted: 20th March 2015
Foreign exchange (FX) is a risk issue that is often overlooked by small and medium-sized enterprises (SMEs) that wish to enter, grow, and succeed in the global marketplace.

Although most UK SME exporters prefer to sell in Great British Pounds (GBP), creditworthy foreign customers are increasingly demanding to pay in their local currencies. From the viewpoint of a UK exporter who chooses to sell in foreign currencies, FX risk is the exposure to potential financial losses due to devaluation of the foreign currency against GBP.

Obviously, this exposure can be avoided by insisting on selling only in GBP. However, such an approach may result in losing export opportunities to competitors who are willing to accommodate their foreign buyers by selling in their local currencies. This approach could also result in the non-payment by a foreign buyer who may find it impossible to meet GBP-denominated payments due to a significant devaluation of the local currency against the pound.

If the FX risk is successfully managed or hedged then selling in foreign currencies can be a viable option for UK exporters who wish to enter and remain competitive in the global marketplace.

The Basics

Exports customers generally prefer to trade in their own currencies.
  1. If you invoice in a foreign currency you will need to convert the GBP value of your invoice to that currency e.g. £1 = $1.60   (so for a £10,000 sale you will raise an invoice for $16,000)
  2. If you invoice in another currency at some point you will need to convert that currency back to GBP.
  3. The time lag between converting the sale to the foreign currency and converting it back to GBP means the value of the sale is open to the volatility of the currencies used.
Example: 
  • Exchange rate at point of invoice: £1.00 = $1.60
  • Invoice raised for $16,000
  • Exchange rate at point of payment:  £1.00 = £2.00
  • Invoice paid at $16,000 and converted to £8,000
  • Loss on exchange £2,000 (20%)
Note that this is an extreme example to illustrate the point. 
  1. Of course the volatility in currencies can work in your favour as equally as it can work against you.  
  2. Management of foreign exchange by forward negotiation or by hedging minimises potential currency losses.
Foreign Exchange (FX) Risk Management Options

There are many option for reducing short-term FX exposure.  However, not all options may be appropriate to smaller or new users due to costs and complexity. Listed below are the simplest techniques. The FX instruments mentioned below are available in all major currencies and are offered by the major banks and some specialist companies.

Non-Hedging FX Risk Management Techniques

You can avoid FX exposure by using the simplest non-hedging technique: price the sale in a foreign currency in exchange for cash in advance. The current market rate will then determine the sterling value of the foreign proceeds. You agree with your customer that the current market rate will apply and he will agree to settle within two business days.

Another non-hedging technique to minimize FX exposure is to net foreign currency receipts with foreign currency expenditures. For example, if you receive a payment in dollars from a US customer you may have other uses for the dollars, such as paying agent’s commissions or purchasing goods or services from other US suppliers. Essentially, you open a dollar account and rarely, if ever, convert to GBP.

FX Forward Hedges

The most direct method of hedging FX risk is a forward contract, which enables you to sell a set amount of foreign currency at a pre-agreed exchange rate with a delivery date from three days to one year into the future. For example, your goods or services are sold to a German company for €100,000 on 60-day terms and the forward rate for “60-day euro” is 1.25 euro to the pound.

You eliminate the FX exposure by contracting to deliver €100,000 to its bank in 60 days in exchange for payment of £80,000. Such a forward contract will ensure that you can convert the €100,000 into £80,000, regardless of what may happen to the GBP-euro exchange rates over the next 60 days.

However, if the German buyer fails to pay on time, you will still be obligated to deliver €100,000 in 60 days.

So, when using forward contracts to hedge FX risk, you should choose the forward delivery date conservatively (you can also request that the FX trader gives you a “window forward” which allows for delivery between two dates as opposed to a specific settlement date). If the foreign currency is collected sooner, you can hold on to it until the delivery date or can “swap” the old FX contract for a new one with a new delivery date at a minimal cost.

Note that there are no fees or charges for forward contracts as the FX trader makes a “spread” by buying at one price and selling to someone else at a higher price.
 
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