Advantages of currency exchange risk management for businesses

In every area of business, there are risks and variables you simply can’t control, but you still take measures to mitigate and protect against those risks, such as a health and safety policy or insurance. While it might not be as visible, the risk of currency exchange rates varying unexpectedly or dramatically can be just as much a danger for a business.

Forward Contracts

One of the most popular ways to control currency exchange risk is a forward contract. This is an agreement made now to carry out a currency exchange on a fixed date in the future. Usually you put up a small proportion of the cash now as a deposit, such as 10%. The key is that you also agree now the exchange rate you’ll use then.

There are several variations on a currency forward contract. For example, you can set a limit order, where you don’t set the completion date, but rather you set the exchange rate you want to deal at. Once the order is set-up, the exchange goes through as and when the market rate hits your chosen limit.

Stop Loss Orders

A stop loss order works in a similar way, but you set a trigger level based on the market rate moving in the “wrong” direction. To put it simply, a limit order means waiting to get a particular deal, while a stop loss order means setting down the worst deal you’ll take if things go wrong. Some companies will combine a limit order and stop order so they can control the full range of possible outcomes.

The Advantages to Businesses

Using forward contracts offers companies that deal with overseas clients and suppliers many advantages. At its simplest, it restricts the degree to which companies are exposed to currency fluctuations that could mean revenue (in pounds) from overseas sales drops or that the costs of importing supplies rises suddenly.

Forward contracts don’t just reduce risk, but in some cases they can offer 100% certainty. A good example is where you make a deal with a foreign buyer that they will pay you for an ongoing order in foreign currency in six months’ time. The problem is that you don’t know how much that payment will turn out to be worth in pounds. You can solve this by setting up a forward contract to exchange the payment into pounds at a set rate in six months, meaning you know exactly how much you’ll be getting, making cashflow forecasting much easier.

Tags: order, exchange, exchange risk management, agreement, Risk management, limit order