Dealing in foreign currency in today’s global market is unfortunately unavoidable, and as a result, companies are often vulnerable to what is known as foreign currency risk. This is where fluctuating exchange rates result in savings or losses depending on whether the currency of the exchange has become stronger or taken a nose-dive. In more simple terms, losses may occur if a product is being imported and the home currency weakens relative to the import currency. This would mean the product would cost more in the home currency, and if this fluctuation had not been foreseen and incorporated into the supplier agreement or into the pricing to the end-customer, then the importer bears the cost. Of course the same can occur in reverse where the importer would inherit the savings.
Unfortunately, completely insuring yourself against foreign currency risk is impossible. However, certain methods can be utilized to best manage the risk so that savings are increased and costs are reduced. The goals of managing foreign currency risk are to account for any foreseeable fluctuations in the prices of payables and receivables, to aim for price continuity for a certain period of time and to gain a comprehensive understanding of the level of exposure so that sound strategic decisions can be made. So how can these goals be achieved?
Managing Foreign Currency Risk for the Foreseeable Future
This requires the use of a few tools such as forward contracts, hedging and options. The use of forward contracts can certainly minimize the risk of losing out on money on payables and receivables. However, a downside is that it can also act to minimize the savings if the company stood to gain from a weakened importing currency. Forward contracts are where both parties agree to a fixed future exchange rate for the transaction (often 30 days). This can be a fantastic tool in establishing some stability in exchange rate pricing for a set period of time, however it also would mean the importer would no longer benefit from a weakened import currency relative to their own.
There are hedging techniques and futures contracts that can also be used to minimize foreign exchange risk. However, these can be risky as they often require large transactions and certainly in the case of futures contracts, they are more difficult to get out of if the result is not heading in a favorable direction. These options are almost like insurance policies, which come at a premium.
Negotiating a Favorable Forward Contract
It is all very well to endeavor to have a forward contract in place, however how do you go about negotiating favorable pricing? This comes from understanding the pricing of the product and the exchange rate between the two specific currencies. It is essential to understand the supplier pricing of the product being imported, as this will be made up of a variety of components, one of which will likely be accounting for fluctuations in exchange rates. Once this is fully understood, sound negotiations can be made with the supplier. This may be that they charge a higher price but must maintain it for a certain period of time (where they are bearing the risk), or that the price may be slightly cheaper but could fluctuate under the influence of exchange markets. It is absolutely essential to establish a few guidelines for a robust contract:
- Denote a reasonable functional currency and the ‘local’ currency.
- Determine how much of the cost is controlled by the ‘local’ currency. This is the exposure to the local currency.
- The baseline rate and the upper and lower limits of fluctuation. This provides a range in which the ‘real’ cost must fall to maintain the current price. If a fluctuation causes it to fall outside the range, then the price is adjusted.
- A validity period for the baseline rate and the fluctuation limits.
If these points are addressed when establishing a forward contract, then both parties can be satisfied with the risk they each bear going forward. It is important to remember that the risk is dynamic and must be owned by one or both of the parties. If the supplier agrees to a forward contract with a lengthy fixed period and large fluctuation limits then they are bearing a significant increase in the risk (while protecting the importer), and as a result they will have likely factored this in and increased the pricing accordingly. Likewise, if the importer accepts reduced fluctuation limits and a reduced fixed price period then they are assuming the majority of the risk, although they are benefitting from a cheaper price. Therefore, in order to be in a good position to establish a sound forward contract, the importer also needs to understand their own exposure and subsequent ability to deal with risk.
Understanding Exposure and Going Forward
Having a good understanding of the company’s exposure to exchange rate fluctuations with their nominated product requires investors or directors to understand the buying markets, selling markets and exchange rates affecting their product. In addition, as exchange rates fluctuate over time, minimization of their affects could be achieved through intimate knowledge of the product, the supply chain, lead times, manufacture times and storage times. This is where an inventory management product such as Unleashed Software comes in, as it is designed to keep track of all inventory that aids understanding and good purchasing and vending decisions.
Article by Melanie Chan in collaboration with our team of Unleashed Software inventory and business specialists. Melanie has been writing about inventory management for the past three years. When not writing about inventory management, you can find her eating her way through Auckland.