12 May 2015 04:58pm

How to manage your currency risk and future currency payments

Fluctuations in the global currency market create uncertainty and can present a significant risk to businesses that need to make and receive international payments in the future. This could be purchase or sale of products and materials, goods and services, or for payroll disbursements to freelance workers and contractors living overseas. This currency risk, if left unmitigated, can lead to significant loss in revenue, budgeting uncertainty, and reduced profit margins. With the right currency products though, many of these risks can be mitigated.

There are three core currency risk issues that businesses typically face, and there is a specific product to help with each:

Issue 1: A need to set a minimum and/or maximum level for a future foreign exchange payment. Requires a limit order and/or stop-loss order

Issue 2: Locking in a future exchange rate for a known future payment or receipt. Requires a Forward contract

Issue 3: Locking in a future exchange rate for a potential future payment or receipt. Requires an Option contract

Specialist currency brokers offer a range of currency risk management tools that help to increase the predictability of future foreign exchange transactions by reducing your exposure to rate fluctuations. Below, we take you through each issue.

Business Issue 1: Need to set a maximum and minimum level for your future foreign exchange payments or receipts

Product: Limit order or stop-loss orders

Solution: Limit order or stop-loss orders are ideal for transactions for which the timing of a currency transfer is not important and the currency risk needs to be managed. These products allow customers to specify the maximum and minimum exchange rate levels at which they are willing to execute a transaction, and therefore the range of funds that will be paid or received. Using these two products together, you can set a predictable range of exchange for regular currency transfers.

Case Study: Funding a foreign subsidiary on a flexible timeline

New Plastic Ventures (NPE) was planning to purchase a new laminating machine for French subsidiary. NPE had set aside the £1.2m for the purchase of this machine, but since the old machine in France was still working, they weren’t in a particular rush to buy the new one.

At the time the exchange rate was 0.7142 pounds for each euro. Since NPE didn't necessarily need to convert their money right away, they wondered if it would make more sense to wait on making the transaction, in case they could get a better rate sometime down the road.

Aware that the rate might move in the other direction, NPE decided to arrange a limit order, which allowed them to buy euros when the exchange rate reached a level they were comfortable with. They also arranged a stop-loss order that would prevent them from losing money if the rate moved in the opposite direction.

NPE placed a limit order to make the currency exchange at a rate of 0.69. If this rate was reached, NPE’s £1.2m would automatically be exchanged into euros. This is the best-case scenario for NPE.

A stop-loss order was also placed at a rate of 0.73. To prevent RVE from having to pay too much on the transaction, if this rate is reached, the GBP £1,200,000 would be exchanged for euros automatically.

By setting these two limits, RVE established a certain level of predictability, since they guaranteed the minimum and maximum amounts they would pay on this transfer. If the exchange was made at the stop-loss rate of 0.73, RVE would have received EUR €1.64m. In the end, the exchange was made at limit rate of 0.69, so RVE’s GBP £1.2m was worth EUR €1.73m when the transaction was made.

Business Issue 2: Locking in a future exchange rate for a known future payment or receipt

Product: Forward contract

Solution: Forward contracts allow customers to take advantage of a favorable exchange rate by locking it in when it’s low, and then executing the transaction at a future date. The potential downside to a forward contract is that if an exchange rate improves, you will not benefit, as you have already locked in a rate.

Case Study: Setting a fixed now price to buy products from overseas in the future

MF Company (MFC) agreed to buy six new super-computers for EUR €400,000 each but didn’t need to make the payment for five months. MFC was concerned that the EUR to GBP exchange rate might move against the company during that time, and decided to fix the exchange rate in advance using a forward contract.

This allowed MFC to know exactly how much these machines would cost on the day they needed to pay for them. MFC fixed a rate of 1.2380 to buy EUR €2,400,000 worth of machines and in the five months before the payment was due the exchange rate moved between 1.2514 and 1.1730. On the day the payment was due the rate was 1.1863.

If MFC had waited until the day the payment was due and exchanged pounds to euros at the prevailing rate, the machines would have cost an extra GBP £88,806.


Business Issue 3: If you think that you may need to make a major international transaction in the future but are not sure if the transaction will happen or how much it may be

Product: Currency options

Solution: An option contract gives you the right, but not the obligation, to buy or sell a particular currency by a future date at an agreed-upon rate, and you can still benefit if the exchange rate moves in your favor. Purchasing an option contract will cost you money whether it is executed or not, but it provides additional benefits that limit and stop-loss orders and forwards contracts do not provide.

Case Study: Protecting against a currency decline when selling to overseas clients

Wind Turbine Company (WTC) planned to sell a wind turbine in three months’ time for EUR €2,800,000 to a customer in France. Worried about possible exchange rate moves, WTC decided to enter into a currency option called a ‘protection option’ and paid a small premium. This allowed WTC to set a worst-case rate to protect the company from the rate declining, but also allowed WTC to benefit if the rate improved. WTC was able to fix a worst-case rate of 1.2013.

Without the protection of an ‘option’, if the rate had moved to 1.2495, WTC would have received GBP £89,910 less for their turbine. However, on the settlement date, the rate had moved to 1.1719, increasing WC’s sale amount by a further GBP £58,470.

Benefits of Future International Payments and Managing Currency Risk

● Manage and reduce your foreign exchange risk: foreign exchange risk grows when transactions are made in the future. By using the products described here, you can lock in a favorable exchange rate and know what you will be paying before your money is sent. This allows for more accurate budgeting and creates healthier margins for your business.
● Save money: you will receive a better rate and pay a lower fee, or no fee at all, for your international transfers when working with a specialist broker to develop tailored currency solutions. The savings can be significant compared to what you would typically pay when using a bank for currency transactions.
● Gain a competitive advantage: when using the currency of your transfer destination, you may be able to negotiate more favorable pricing for your international payments.

Future International Payments Risks and Issues

There is always some risk involved when making foreign exchange transactions, especially when transactions are made in the future, as rates can fluctuate significantly in volatile currency markets. Specialist currency brokers make it their business to help you and your business navigate these fluctuations and mitigate risk with solutions like limit orders, futures contracts, and options.

There are, however, some specific risks associated with forward contracts and options that are important to keep in mind. With forward contracts, it is possible that you may lose out on any upside if the exchange rate improves before your contract is executed. And, while options offer the ability to benefit from currency fluctuations if they move in your favor, they also cost more up front, and that cost is not recoverable in the event that your option contract is not exercised. For all these products, consult with a specialist provider who will be able to tailor a solution to your needs.

Daniel Webber is the Co-Founder and Managing Director of FXcompared, the leading independent resource to compare and find the best International Payments solutions.