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An international affair

If you’re directly trading with a supplier or customer overseas, a currency movement in the wrong direction can take a small profit to a huge loss. But, as Adam Bernstein explains, all is not lost.

PROFIT is a function of revenue less cost, so anything that increases the former and decreases the latter must be considered.

The obvious thing to do is sell more while targeting expenses such as staff, premises, fuel, utilities and raw materials. But how many think about currency, especially where transactions aren’t made in sterling? Do they ever consider what would happen if the euro moved 2% the wrong way?

With a good proportion of product for the flooring sector coming from overseas, it follows that firms shouldn’t expose themselves unnecessarily to the vagaries of the exchange rate market.

Protect the position
The problem of currency volatility is important to Tom Foster, senior corporate dealer for Central FX. He knows ‘very few people, if any, can reliably predict the movement of currency markets’. Further, ‘failing to sufficiently protect your business against adverse rate movements can lead to significant and unforeseen losses on your bottom line’.

It’s also why David Johnson, director of Halo Financial considers protecting a company’s position on foreign exchange needs ‘is no different to any other kind of good governance’.

But just as no two companies are the same, so Foster sees risk profiles of different firms as always being different. However, he says ‘as a rule-of-thumb there are some general considerations that should be made’.

In more detail, he says ‘any business involved in foreign exchange should have a budget rate they work from. This can be used to forecast costs when importing or exporting goods. It’s essential this rate is protected to some degree. Failure to do so coupled with adverse rate movements can mean profit margins are eroded. Firms will then be forced to hike prices to combat this, something that won’t typically go down well’.

Foster therefore sees a fine balancing act between no protection and too much protection.

And Johnson agrees. He too sees that without exchange rate protection, there’s a risk of writing off profit or even creating a loss.

On a positive note, ‘there’s a possibility the exchange rate could move in the company’s favour’. But that, as Johnson, says, is ‘like managing risk based on a coin flip’.

Risk options
How a firm manages its risk will depend on its appetite, and in Johnson’s view, it’s all about a strategy that ‘covers a percentage of the open positions and increasing that cover as the payment dates or revenue receipt dates approach’.

He says some firms work on a 50%-30%-20% percent ratio, where 50% of all known currency needs are covered as soon as they’re certainties, 30% is covered nearer to the settlement dates or if a sizable swing in the rate is seen, and 20% is left until near the settlement date.

He sees larger corporations favouring a more structured approach, while smaller owner managed businesses tend to be more agile.

As to the tools that can be deployed, there are several which Johnson outlines:
There’s the forward contract that gives certainty over the exchange rate and removes any risk. A downside is the company can’t use it if the exchange rate improves. Also, it often requires the payment of a deposit or bank charge over some of the company’s assets to mitigate their risk.

Next is the spot contract. This removes risk, but trades are settled immediately. These are useful for cash-rich companies with currency accounts that can switch funds between currencies; it’s less of an option where cashflow is tight.

Another possibility is the bracketing of exchange rates with automated market orders. These come in various guises. There’s the stop-loss order, an automated order placed with a broker below the market to act as a safety net; this ensures the firm receives at least that selected rate even if the exchange rate collapses.

Then there’s a limit order, sometimes called a take profit order, which is placed above the current exchange rate in a bid to capture spikes in the exchange rate that can enhance bottom-line profit if the order is triggered.

When used in pairs, these orders are known as OCO – one-cancels-other. Just as the description implies, if one order is triggered the other is cancelled so firms don’t end up with two contracts.
The other commonly used tool for larger corporates is the option. This grants the right to buy and sell a fixed number of currencies at a predetermined exchange rate by a specific date. If the market moves in a firm’s favour, it can ignore the option and trade at the market rate. If, however, the market moves against the firm, it can exercise the option.

They either carry a premium – a few percentage points of the value of the contract. If not, then there’s usually a pair of options packaged together and there’ll be a potential negative outcome, dependent on the market movement. Options, in Johnson’s view ‘should be treated with genuine suspicion until you fully understand the catches or the full implications of potential downsides’.
But no matter the tools to be used, Foster recommends firms ‘put together as detailed a forecast as possible of their expected requirements, then send this over to a currency specialist. They can then conduct a risk assessment which covers several factors such as profits margins, a client’s ability to change price, budget rates, and payment terms etc’.

Once completed, the client will be provided with policy that’ll allow them to better formulate their currency plan.

DIY or employ a specialist?
With the tools outlined, some think they can take bull by the horns and do the job themselves. However, Johnson urges caution. In his view, ‘monitoring the market is simple enough but the problem is the amount of information online which can be overwhelming’.

Further, the number of opinions available are countless and often conflict. But for him, that’s essential because, ‘if there were no conflicting opinions, there’d be no market… when one person buys another sells and both believe they’re being astute’.

Also, the volume of information varies according to the prominence of the currency. Put simply, a specialist will have a greater overview of the markets as well as having a better understanding of the ways in which firms can manage transactions, limit risk, and protect against unexpected events.
Foster takes a different approach and notes the need to have security of funds as it ‘is paramount to any business’.

He says it’s imperative the chosen specialist adheres to all the required regulations and, preferably, has been established for at least five years.

He recommends ‘ensuring there’s some synergy between the two businesses as brokerages specialise in different areas… a good relationship with your account dealer is key – you’ll want to feel confident your funds are being managed correctly and efficiently’.

So, with the need to engage a specialist, how should one be chosen? For many, a recommendation is the route they choose. But if that isn’t possible, then Johnson recommends looking at how the specialist is regulated: ‘The FCA has several categories of regulation. Authorised payment institutions and e-money firms are required to segregate client funds and have a specified level of capital adequacy. Alternatively, check that the specialist is on the register of payment institutions.’

And then there are brokers that can trade in options. Johnson says they’re regulated as investment houses and face very tight restrictions.

All firms in these categories are under https://register.fca.org.uk/s/
Fundamentally, Johnson’s advice is that ‘if you’re seeking a fully online offering, you’ll have to be guided by testimonials and rating companies such as Feefo as well as the company’s website’.

With an eye to the cost of currency mitigation, Foster says pricing may differ according to the required currency trade – a spot payment of sterling into euros, for example will differ from a year-long forward contract of dollars into sterling. However, he adds that ‘most brokerages earn their commission through the rate of exchange they are able to achieve themselves and the one offered to the client’.

Johnson confirms that costs depend on the tool deployed: ‘With spot contracts, the only cost might be the TT fee for moving your funds, but forward trades usually require some form of upfront deposit – called a margin.’

However, he reassures by saying this is a part payment, so is not really a cost. Importantly, though, he warns that ‘if the exchange rate moves significantly while the position is still awaiting settlement, you may be ‘margin called’. In this case, the broker will ask for further part payment to provide protection for them against default.’

As for options, Johnson says they can be utilised with no upfront cost, but the potential downside needs to be fully understood in these cases. But if there’s a cost, he says it’ll be charged as a fee for entering the option into the market, known as a premium: ‘The amount of the fee will depend on the size of the option, the volatility in the currency pair involved and the time between the booking and expiry date of the option. This premium can be anything between 0.5-4% depending on the variables.

Foster offers, ultimately, very clear advice: ‘Protect the budget rate. Nobody can reliably predict exchange rate movements and a good rate today may end up being a bad rate tomorrow.’

Other tools
Beyond using the markets, payments can also be sent and received via a company’s own foreign currency accounts. In fact, Johnson sees companies find flexibility in currency accounts – ‘especially so if they have receipts as well as expenses in particular currencies’.

An example he gives is dollar receipts being used to make dollar payments without incurring any exchange rate spreads.

And the dollars can be exchanged directly into euros to pay euro invoices without having to convert between dollars and sterling before converting again into euro. Another benefit of currency accounts that Johnson highlights is that ‘they can be topped up when exchange rates are attractive without the need for forward contracts or options’.

And Foster agrees, noting that ‘firms operating only a sterling account are open to enormous margins being charged by banks for receiving non-sterling funds. By holding additional currency accounts, these funds can then be deposited and converted at a far better rate of exchange’.

He adds that these accounts can be opened with a broker (as well as a bank).

In summary
Currency management isn’t necessarily the most important consideration for a board, but it should be. With thin margins, a minor swing in the value of a currency can have a disproportionate effect.
Adam Bernstein is an independent columnist

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