It’s a fact that today’s marketplace is becoming increasingly global. Businesses are able to source their inventory from more and more countries, and whether you love them or hate them, the rising number of free-trade deals is making this cheaper to do. The increase in choice, and the ability to make cost-savings by importing inventory are fantastic for a business, but managers must be aware that there are risks associated with this too. One of the most prominent of these is foreign currency risk.
What is Foreign Currency Risk?
Foreign currency risk, also known as foreign exchange risk, is the risk of exchange rate changes negatively affecting your business. Because most of the world’s major currencies are floating currencies, meaning they can be freely bought and sold on the open market, they are subject to change due to market conditions. This is much like the price of any normal good or service. Not all currencies are freely floating, for example, the Chinese Yuan. But even a managed currency has associated risks, as its stability is reliant on the ability and willingness of its country’s government to keep it at a stable rate.
When importing inventory, you can lose money if the currency that you are using to pay for your materials increases relative to your home currency. This means that you will have to pay more for your imported inventory, because in order to complete the transaction, you must first buy the transacting currency in order to pay for the goods. For example, a New Zealand clothing retailer may import the clothes they sell from China, buying a shipment of shirts for US$2000 (it is common for transactions to occur in US$ as this has historically been a world standard). If the USD/NZD rate rose from 1.25 to 1.5, then you would go from having to pay NZ$2500 for the shirts to NZ$3000, leaving you a further $500 out of pocket than under the previous exchange rate.
While movements in exchange rates are simple enough to understand, there are several different types of exchange rate risk. There is the short-term risk, whereby exchange rates move during the time it takes to gain agreement during a transaction (until the transaction is settled). This can happen if you decide to make an order several weeks in advance as businesses often have to. Then there is the longer-term risk of currency movements causing a permanent fall in profitability. Exchange rates rarely have dramatic changes from day-to-day or week-to-week, but a long-term fall in your home currency could cause you real problems. Other types of currency risk exist also, such as when you have operations overseas, or when you export some or all of your goods in addition to importing inventory.
How Can I Manage This Risk?
There are multiple strategies to handle foreign currency risk, but they come at a price. What is best for you will be determined by the characteristics and needs of your business.
For short to medium term currency fluctuations, you can take advantage of numerous financial instruments that allow you to hedge your position. One example is foreign exchange forward contracts. These allow you to enter a contract to buy a certain quantity of foreign currency (i.e. the currency you need to buy your inventory) at a specified time in the future. For example if you make an order of stock that will be settled in a month’s time, you could enter a 30-day forward contract to buy the purchase price you need, guaranteeing a specific exchange rate for you at that time.
Futures contracts and options are other possibilities. It is important to realise that there are transaction costs involved in entering these contracts, which means if your purchases are not substantially large, it may not be worth it for the transaction costs you pay. Also, while hedging eliminates the risk, this also means it eliminates the possibility of exchange rates moving in your favour, making your imports cheaper. Given transaction costs, you always have the option to take on the risk yourself, and chance the gains and losses that result, as long as your exposure to risk is not excessive.
Another option is to negotiate the terms of your supply contract to suit your needs. Whether you can do this will likely depend on the relative bargaining strength between you and your supplier. One example would be to transact in your home currency. If your supplier is from overseas, they will likely charge a premium for doing this, so make sure you take this into account. Also be aware that while you may be paying in your home currency, exchange rates will continue to change. Hence, you must be alert to these changes affecting your transaction. Ask the questions – is your supplier benefiting when his home currency is weakening, or are they somehow pricing their losses into your contract in some other way?
It is hard to manage long-term currency trends that do not go in your favour and exchange rates can play a huge role in market conditions and competitiveness. This has been shown historically by numerous national governments who have manipulated their currency to try to advantage their domestic industries against overseas firms. If faced with a negative trend, financial instruments like forward contracts aren’t a long-term solution. You may need to change the way you source your inventory, looking for suppliers from other countries, or even moving your production overseas.
Explore Your Options
The focus above has been on managing currency risk when purchasing your inventory. If you also export your final product overseas, you face further exposure to currency risk, and while the same principles apply you should seek more information on export-specific risks also. Ultimately, when dealing with any type of foreign currency risk, the key is to assess the extent of all types of risk, and what options are reasonably available to you. This will help you to come up with a strategy that suits your individual business needs. And of course, systemizing your business processes with an inventory solution such as Unleashed will most definitely also help!
