David Lamb of foreign exchange specialists FEXCO, discusses the implications of unpredictable exchanges rates for UK manufacturers.
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.
And this autumn has seen more than its fair share of swings; Sterling slumped 5.3% against the Euro in just one torrid week in August.
In the current economic climate, margins are so tight for many manufacturers that such sudden swings can be the difference between making a profit and 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.
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.
Whatever you’re doing, importing materials or buying a new factory overseas — you need to hedge against this risk.
But too few companies properly account for the volatility of the currency markets, and fewer still make use of the various strategies that exist to limit the risk.
Forward contracts: With forward contracts, you buy a currency now with a small deposit – typically 5% – that enables you to lock into a specific rate. However, you only pay the remainder when you actually need the money. The fixed rate protects you from the potential for a sharp move against you when you eventually make the payment. Forward contracts can usually be fixed for up to a year.
Limit orders: This is where you set a target exchange rate, at which, if achieved in the markets, you will buy your currency. Limit orders are useful if you have upcoming payments but you are not restricted by tight deadlines and therefore have time to try and achieve a better exchange rate than what’s available at the current time. This tool provides assurance to businesses that should the ultimate exchange rate be achieved, even if that occurs in the middle of the night, their trade will be triggered automatically.
Stop loss orders: This is where you set a minimum exchange rate, which, if achieved in the markets, you will buy your currency. Stop loss orders are often used where there is a high risk or concern of adverse movement in exchange rates, enabling clients to protect their bottom line and reduce the risk of exposure to such negative movements.
The pound’s steady rise in value this year has made British goods relatively more expensive for overseas customers, making life tougher for exporters.
The flip side is that for those that import materials or components, imports have become cheaper.
While these longer term trends will affect a business over time – either for better or for worse – short-term volatility can wipe out the profit on an individual transaction.
Forward contracts offer companies the reassurance of knowing that when they agree a deal with an overseas client or supplier, they will know exactly what sums will be involved – and that their profit margin won’t be swallowed up if the exchange rate changes.
By locking into an exchange rate, a company could miss out if the currency movements go in its favour, but that risk is surely more than outweighed by the benefit of being protected if the exchange rate movement goes against it.
Small and medium-sized manufacturers are unlikely to have the cash reserves to bail them out if an overseas deal goes wrong because of currency fluctuations.
More than anyone else, they should use hedging strategies to ensure that when they expose themselves to overseas markets, they’re not also exposing themselves to unnecessary currency risks.