Managing foreign exchange risk in times of high volatility

Any currency can experience periods of high volatility. The current COVID-19 situation is introducing levels of volatility in foreign currency markets not seen since the 2008 Global Financial Crisis.

These levels of volatility can make or break a business that relies on importing or exporting goods. However, you can minimise these risks by having the right measures in place.

What is foreign exchange risk?

In simple terms, foreign exchange risk is the risk imposed on a business’ financial performance by changes in currency exchange rates. These fluctuating exchange rates can damage a business’ profitability by eating into margins.

Sources of foreign exchange risk

Essentially, any situation in which a business uses foreign currency can be considered a foreign exchange risk. But businesses that deal with more than one currency are more prone to foreign exchange risk than others.

These risks can come from:

• Receiving income (including interest, dividends, royalties, etc.) and revenue in foreign currency
• Needing to make payments in foreign currency to suppliers
• Business loans made in foreign currency
• Holding offshore assets, such as international business subsidiaries.

The danger for businesses

There are a number of ways that volatile foreign exchange can impact your business.

• If you’re an importer, a falling domestic exchange rate can increase import costs, damaging your profitability. For example, if you are an Australian business importing from the US, a falling AUD can be harmful to your business.
• If you’re an exporter, a falling exchange rate typically benefits you as your product pricing will become more competitive. However, a rising exchange rate will be harmful to your product pricing.
• If you’re a local producer, rising domestic exchange rates can give importers more of a competitive edge over your products, and you lose your business to overseas producers.

But while typically volatile exchange rates can make a business nervous, there are a number of proven strategies that enable effective hedging against foreign exchange risk.

Managing foreign exchange risk

Spot transactions

Spot transactions, or spot contracts, are probably the easiest way to manage foreign investment risk. A spot transaction is a single foreign exchange transaction where you purchase and settle the amount ‘on the spot’ (or rather, within two business days). It provides very little notice time, and a shorter window for risk, so if you’re happy with the current foreign exchange rate, you can book in a conversion with a spot transaction. While this might mean you forego a better rate in the future, it does minimise the risk of future volatility in your desired foreign currency right now.

A Forward Exchange Contract (FEC)

A FEC allows your business to guard itself against price fluctuations by locking down an exchange rate at the current price, which is valid until a date set by you. While this contract provides peace of mind that you won’t actively lose money on your foreign exchange, it does mean that you can’t take advantage of any positive shift in foreign exchange rates.

Another downside is the fees imposed on this contract. A FEC locks in a specified sum of money. So for example, if you lock in US$10,000, but at the end of the contract you only needed US$8,500, then there is a contractual cost to cancel this remaining portion.

Natural hedge

For businesses that are already selling overseas (for example in the US), foreign currency bank accounts can also provide a great way to provide a natural hedge. For these businesses, rather than receiving in USD and converting to AUD, you can leave your USD balance in your USD foreign currency account. This is especially convenient if you have expenses also in USD as you can hedge against any fluctuations in AUD by just holding USD in your account. You also save on any potential double conversion fees the banks may charge (for example, converting from AUD to USD and then back to AUD).

Foreign currency bank accounts

A simple way to manage foreign currency risk involves setting up a foreign currency account . Then, to hedge against risk, simply deposit the required amount (plus a nominated surplus) into the account. This method allows you to make the most of FX rates when they’re strong by converting and holding the foreign currency until you need to make payment. It also ensures the correct funds will always be available and takes into account the potential fluctuations of the currency.

Article originally published by Airwallex.