How UK businesses should manage currency risk

Trading with eurozone countries these last four years – since the eurozone crisis began – will have rightly provided many British SMEs with cause for concern. The volatility of sterling and the euro has prompted much anxiety. In 2013 alone, the pound has fluctuated between €1.14 and €1.23. A transaction of €50,000 made at either end of that value scale would have differed by £3,200 – a very significant sum for any SME.

Cyprus aside, news coming out of Europe has taken a more positive slant of late. But only the rudely optimistic would bank on no further major events driving sudden currency shifts. So what can (and should) small and medium-sized businesses be doing to manage their currency risk?

1. Know the score

First and foremost, businesses need to understand their overall exposure. Any business with trading or manufacturing partners in multiple countries will quickly build up a complex web of currency liabilities so keeping track of them and recognising the current value of future payments or receipts is hugely important.

Only once you have a good grasp of your exposure can you start taking steps to mitigate currency risk. Foreign exchange providers that help businesses manage these exposures should provide treasury functions (through an online portal) to make that task easily managed.

2. Passing the buck

A seemingly obvious solution for a UK business trading overseas is to look to pass on the currency risk of any transaction to the foreign buyer or seller. A British business paying manufacturing costs to a firm in Europe may try and insist on payment in sterling, leaving the manufacturer to shoulder the risk of converting that sterling amount to a volatile euro.

In reality, many SMEs won’t be in a position to negotiate those terms and, in fact, simply passing on risk can be counter-productive. If a UK firm sells goods to a company in the US and insists on payment in sterling, the competitiveness of their product will sink rapidly if the dollar weakens against the pound.

3. Planning trades

Rather than just pass on risk, businesses should look to lock-in favourable rates for their trades. They can do so in a number of ways.

Forward Contracts allow businesses to buy a fixed amount of foreign currency at a specified point in the future at an agreed fixed rate. A company needing to purchase goods worth €50,000 in six months’ time could, hypothetically, purchase a contract to buy the necessary euros at £0.85 each. If they did so, and in six months the euro had strengthened to £0.90, they would have saved themselves £2,500 (€50,000 at £0.85/€ is £42,500 – at £0.90/€ it is 45,000.) Of course, the euro may weaken but the primary business benefit is in knowing the exact value of any obligations and so being able to budget accordingly.

Options products can protect against adverse currency movements, therefore providing the same security as a Forward Contract. Significantly, however, they offer a degree of upside if currencies move in a favourable way. Options products are generally structured at zero premium, so you pay nothing to enter into the contract. They can be particularly effective for companies who need to fix customer pricesfor a six month or 12 month period but foresee potentially beneficial moves in an exchange rate.

The “Protection Rate” of the Option – the rate at which the exchange will be least favourable – acts as the guaranteed, budgeted rate. If the exchange rate moves favourably, companies can benefit to some extent from that change, securing a better deal that can translate into increased profit margin or enhanced product competitiveness.

4. Playing it straight

Ultimately, for most businesses, managing currency risk is about limiting the impact of volatility. More complex instruments like Options do give you the opportunity to secure the very best rate but what’s most important is knowing the rate you’ll achieve so you can budget and forecast accordingly. If you’re fully aware of your exposure and manage its risk accordingly, you can concentrate on your core business, confident that the next jump or fall in the euro won’t undermine hard-earned profits.

Guido Schulz is global head of strategy of AFEX, a non-bank provider of global payment and risk management solutions.

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