A fast growing venture that is expanding beyond its domestic market asked me how they might deal with the foreign exchange risk given they are in a thin margin high volume business.
For a business that is going to do cross border trade getting the foreign exchange processing right can impact the cost of buying and selling globally and whether the business is ready to expand into new markets.
-First rule in FX, is do not do it....meaning if you can keep the currency flowing in the same currency it is much better to deal with. Each time an exchange happens it is losing value in both directions due to the fees.
- Second rule, determine your base currency and do not change it, that is the currency from which the left side of the exchange happens, it is also the currency of your accounting.
- Third rule, try and stick with one of the most common currency pairs for trading EUR/USD: The euro and the U.S. dollar USD/JPY: The U.S. dollar and the Japanese yen GBP/USD: The British pound sterling and the U.S. dollar USD/CHF U.S dollar and Swiss Franc. This is mostly what the currency markets trade in.
- Understand that many different rates exist, Fixed Exchange Rate System (or Pegged Exchange Rate System). 2. Flexible Exchange Rate System (or Floating Exchange Rate System). 3. Managed Floating Rate System. For a business they mostly interested in the Floating exchange rate but this is problematic.
- Understand that the FX rates are quoted intraday, spot, are at the same hour each day and other ways so understand what you are doing is really important.
- One of the strategies that are used is to pool the funds first and only do the FX at favorable rates, but this is akin to daily cash management and then your CFO is then acting as a FOREX trader
- One possibility is to use a Currency Futures Contract. Do not confuse this with a Currency Forwards Contract. The main difference is that a Futures contract has standard sizes and durations whereas a Forwards contract is done OTC. Both can be used but it take some management to balance the two.
- Consider a Currency Futures Contracts where you lock in the rates for some duration of time based on internal calculations. With some contracts you only pay 5 to 10% of the amount upfront to lock in the Future Rate, if at the time that you do the exchange the rate is higher then this is in your favor, if lower then you don't get the better rate, future rate you bought protects against that risk. In effect, it smooths out the currency fluctuations.
- One of the reasons for doing the future contracts is just be able to figure out the accounting, trying to do time series accounting is crazy, so you have to use some means of doing it and this is usually a spot rate for the day but even that gets really messy, so smoothing out the FX rate with a Future Contract starts to make things easier to manage.
- One strategy is to use the dollar cost averaging over time where you are buying the same amount of FX each day at the same time, and this smooths out the highs a lows.
- In terms of what you show the foreign buyer or supplier, you have to always show the currency you have and not convert it. You can give them a utility to convert at some rate they enter or show a choice of rates, or a rate for that day but qualify this clearly that what they are seeing may not be what gets transferred due to currency fluctuations.
One of the major challenges with all of the above is the company cash management. Freezing up cash this way is challenging but it is part of every business. You can deal with it as revolving credit but then that add more cost to the money and it would have to be calculated into the rates.
You should talk to your banker and ask them about all of the above to see if they have a multi-currency bank account that reduces some of the fees for moving money between accounts.
Managing the foreign exchange when doing business internationally can make the difference between making or losing money so learning how to setup the processes and keeping them consistent is an important part of being a global business.
Launch a Global Business
A Guidebook for SME Internationalization - Small to Medium Enterprises are accessing the global markets via New York City
by Ray Garcia
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