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To get a grip on your business’s foreign exchange strategy, it’s important to understand the ins and outs of exchange rates and trading tools.
At first, the world of foreign exchange can appear complex and risky. But getting a grip on it is easier than you think, and crucial if you want to keep your business ahead of the game.
To get that education started today, here’s an insider’s guide to reading currency exchange rates.
Spots vs Forward Rates
An exchange rate is the rate at which one country’s currency is exchanged for another.
The spot rate refers to the current exchange rate, while a forward rate is a contract to exchange two currencies at an agreed rate at a future date. This can be at a premium or discount to the current spot rate.
Let’s look at an example.
Say your business is based in Australia and you’ve agreed to purchase goods from a Japanese company with payment due in Japanese yen (JPY) 30 days from now.
Over the next 30 days, fluctuations in the spot rate mean the goods could end up costing you far more or far less than what they would cost today.
What is Hedging?
You can’t predict the future, so to protect against fluctuations you might take out a forward contract to lock in a future exchange rate for AUD to JPY. This process of protecting against future movements is called hedging.
Hedging provides certainty around future costs, allowing for better management of cash flow.
Dealing in the Spot Market
As part of a foreign exchange strategy, you may also look to trade foreign currency directly in the spot market. This might be to cover more immediate international expenses, take advantage of favourable rates or build foreign currency reserves.
Whatever the case, there are a number of tools available to minimise the risk you face in this type of trading.
Limit Order
Limit orders are used to buy or sell an amount of foreign currency at a specified exchange rate. In the event the currency is trading at this ‘limit’, the order will be executed.
Stop Loss
A stop loss protects the value of your holding by establishing a low water mark, which represents the maximum you’re prepared to lose on the trade. If the value of your holding declines below this low mark, your holding is liquidated to ensure losses don’t increase.
OCO Order – (One Cancels The Other)
An OCO order is a combination of a limit order and a stop loss, with the added condition that if one of these orders is triggered, the other is cancelled.
For example, an OCO could be used to set an upper limit order and lower stop loss at which your holding is to be sold. If one is triggered, the other is cancelled, which means your currency holding is free to trade within this pre-set range.
So those are the key terms and tools you need to know. The next step is to involve an expert foreign exchange partner - one that helps make sense of the market and guides your business in reducing currency risk and maximising returns.
