A guest thought-leadership article from Matt Richardson – founder of the impartial foreign exchange broker, betterFX.
European summits are seldom events to set the pulse racing. Yet the 28 Prime Ministers and Presidents gathered in Brussels today could fire the starting gun on a race that will spark passions, divide the nation and ultimately determine Britain’s future.
True, the road to the referendum on whether the UK should stay in or leave the EU will be long, and many twists and turns lie ahead.
But the very thought of Britain leaving the European club – or Brexit for short – has already sent the currency markets into a funk.
This week, Sterling volatility against the Euro – the speed and severity with which the exchange rate can yo-yo up and down – hit an all time high. And we don’t even have a date for the vote yet!
Manufacturers feel the pain
Of course if you spend your day running a busy production plant it’s easy to feel safely detached from the currency markets.
But volatile exchange rates aren’t just a problem for City traders. In fact manufacturers that import raw materials or components are among the businesses most likely to be affected by swings in the value of the Pound.
In the current economic climate, margins are so tight for many manufacturers that sudden swings can be the difference between making a profit or a loss on a deal.
In the most extreme cases, falling foul of exchange rate volatility can tip a struggling business over the edge.
Keeping currency risk at bay
If you’re an importer, you must either react to the exchange rate moving against you by increasing prices or accepting reduced profits, or even losses.
The bad news is that you cannot be in a position where you always win on the ups and downs of the currency markets. But the good news is that you can protect your business from serious damage by having a clear plan.
It might sound complicated, but in fact it’s not.
Unless you specify otherwise, when you buy foreign currency (i.e. send funds overseas to pay a supplier), the conversion will be made at the rate of the time and day.
This exchange rate can go up or down, meaning that each time you make the same transaction, it could cost you more or less.
Banks and foreign exchange companies often encourage companies to hedge against the risk of the exchange rate moving against them by taking out what’s know as a ‘forward contract’.
These allow you to agree an exchange rate now, for a date in the future. That means you are protected from the rate getting worse for you – but the flipside is that you will miss out if the rate gets better.
So while many banks and foreign exchange firms will be keen to sell forwards or other FX hedging products, in many ways hedging or not hedging is a gamble either way.
The key thing here is to weigh up the relative upside and downside risks to your business.
If a 10% exchange rate move against you would cause severe damage to your company, but a 10% move in your favour would make a good year great, what is the right approach?
Every company is different, but this choice is an important one for all firms to consider carefully. But remember, there is a reason banks and foreign exchange firms like to push forward contracts and other hedging products at clients – these complicated instruments make it easier for them to hide the margin they are taking.
It’s not just importers
Exporters are equally at the mercy of the currency markets – albeit in reverse. So while the importer celebrates a stronger Pound, exporters suffer as their products suddenly become more expensive.
So what can businesses – both large and small, importers and exporters – do to avoid unexpected and unwelcome damage being inflicted by the volatility of the foreign exchange markets?
The key thing is to have a plan for all the most likely scenarios. Looking at charts of how exchange rates have moved in recent years is a good starting point.
In the past year alone the Euro has ranged from 1.44 to 1.27 to the Pound…. can your business survive and profit anywhere in that range? If not, then you need to think about how you will react as the exchange rate moves – either up or down.
If you export, consider allowing your customers to pay you in their own currency (this is easier than you might think) and if your business mainly imports, consider ‘stocking up’ on foreign currency when the rate is at a good level for you.
Of course, whether it is foreign exchange, equities, commodities or any other asset, never let the gambling urge to pocket the upside gains put your business fundamentals at risk!