Forex volatility can be fuelled by a range of factors, but especially political upheaval. Events like the Brexit referendum result and the US Presidential race in 2016 meant businesses had to get used to increased exchange rate instability. For those with overseas interests the inevitable disruption to currency markets caused by political uncertainty can hit the bottom line. Yet there are ways SMEs can take control of their currency exposure.
How volatile is forex?
Political events have precipitated severe short term peaks and troughs within foreign exchange markets over the past twelve months.
When Britain voted to leave the EU it sent the pound crashing to a 31-year low the day after last year’s historic referendum. By close of trade that day, sterling was down nearly 9% against the dollar 1.
Not long after the referendum, the pound surged against the euro, when Donald Trump won the US presidential poll in November 2016. The result hit the value of the euro, as investors considered the impact of rising populism across Europe. Sterling registered its best two-week performance against the euro for eight years .2
Not every election or political event will surprise businesses, but it's important to prepare for the possibility of the unexpected happening.
The impact of volatility
Currency fluctuations of the size and frequency we’ve seen in recent months can be fundamental – eating into the margins that define the boundary between profit and loss.
For example, if a UK firm is paid €300,000 by a customer, a fluctuation of 0.025 in the exchange rate could cost the company close to £10,000 in the single transaction required to repatriate that revenue into sterling. Less than halfway through the year the exchange rate between GBP and the EUR has already see-sawed by that margin five times.
The impact can be even greater for those who have to hold money in another currency for longer – for example those held to long payment terms, or those that take payment from a UK customer long before they pay an overseas supplier such as a travel agent.
In addition to reducing profitability, as costs go up, or income falls, these sudden movements can also squeeze cashflow, forcing firms with a lot of overseas business to hoard greater cash reserves and hold back on investment.
With the uncertainty of Brexit negotiations, SMEs are being forced to proactively manage their forex risk. So, short of buying six extra computer screens and becoming a fully-fledged trader, it’s difficult to know how to insure against foreign exchange volatility in the current climate.
Hedging forex exposure
Businesses generally prefer stability, and those unwilling to face the unknown risk of full market volatility may look to currency hedging as an option.
Simple forms of currency hedging like forward contracts can effectively protect a business from exchange rate volatility by guaranteeing a fixed rate.
By taking out a forward contract, a company can agree the exchange rate it will receive against an invoice, for up to a year ahead. Think of it as the forex equivalent to the difference between a fixed rate mortgage and a tracker.
Going back to our British company with an invoice of €300,000 due, a forward contract will guarantee the sterling-euro exchange rate it will get on the day the payment is due, giving the business complete certainty over the value of a foreign invoice.
Of course, this means that the company may benefit less if the exchange rate moves in its favour. But the advantage is that its currency risk is managed. This allows financial directors and business owners to plan everything from pricing strategy to diversification with the comfort of known margins on individual sales or invoices.
Types of forward contract
There are two types of forward contracts that SMEs can take advantage of:
- Fixed Forward Contracts fall due on a specific date within 12 months. On that date, the agreed amount is exchanged at the agreed rate.
- Window Forward Contracts provide greater flexibility and control. They allow for multiple foreign payments to different companies within the 12-month period, at the agreed exchange rate.
Forward contracts are generally taken out against a certain invoice. But for more flexibility, there’s the option to go for what’s called a ‘blended’ approach. In this case, the forward contract applies only to an agreed percentage of the invoice in question. The rest is exchanged at the market rate on the day of the transaction. In this situation, the company using the forward contract still stands to benefit from a possible improvement in exchange rates, while greatly reducing the risk of rates moving the wrong way.
This allows businesses to determine where their red line is in terms of the value they don’t want an invoice to fall below.
By mitigating the risk posed by forex uncertainty, forward contracts may be used to protect margins and cashflow, which in turn may enable more accurate budgeting and forecasting. In short, forward contracts can help to create an element of certainty in uncertain times.
- Pound plunges after Leave vote, BBC News; https://www.bbc.co.uk/news/business-36611512
- Pound has best fortnight in eight years after Trump win, The Guardian, http://www.theguardian.com/business/2016/nov/11/pound-trump-euro-brexit-sterling
- Pound soars to six-month high after Theresa May calls general electionbut £46bn wiped off FTSE 100 in worst day since Brexit vote, The Daily Telegraph, https://www.telegraph.co.uk/business/2017/04/18/pound-touches-three-week-high-against-us-dollar-ftse-100-suffers/