10 Aug 2017 12:31 PM

UK companies, large and small, deal with overseas customers and suppliers meaning they often have to pay suppliers in foreign currency. Unless exchange rates are fixed, there is risk. With Brexit and overall international uncertainty, this is becoming a key issue for businesses. So here's a brief overview of the two main types of currency risk that affect SMEs:.

Transaction risk

Transaction risk arises when a company is importing or exporting. If the exchange rate moves during the period between agreeing the contract in a foreign currency and paying or receiving the cash, the amount of home currency paid or received will alter, making those future cash flows uncertain.

For instance, if a deal is agreed by a UK business to sell goods to a French business today for €10,000 and payable in three months time, then the amount the UK business anticipates receiving today is £9,009 (10,000/1.1). If in three months time, the exchange rate is 1.2, the UK company will receive £8,333 (10,000/1.2). On the other hand, if the exchange rate is 1.0 in three months time, the UK company will receive £10,000 (10,000/1.0)

Transaction risk management is not only concerned with achieving the most favourable cash flow but also aimed at achieving a definite cash flow.

There are several ways in which transaction risks can be mitigated:

Invoicing in local currency: Arrange for the contract and the invoice to be in your own currency. This shifts the exchange risk from you onto the other party. You may need to negotiate with the other party to agree which of you will bear the risk and to what extent. It is also advisable to agree who will bear any transaction fees as these could add up to a significant sum for a regular customer/ supplier.

Netting: If you have customers and suppliers in the same overseas country, then you can net off one against the other. For instance, if you owe suppliers €15,000 and a customer owes you €20,000, then the net exposure is €5,000. If you pay the supplier at the same time you receive money from your customer, the exchange exposure is restricted to €5,000.

Matching: If you have a sales transaction with one foreign customer, and then a purchase transaction with another (but both parties operate with the same foreign currency) then this can be dealt with by opening a foreign currency bank account. This can only work if the timing of inflows and outflows are close to each other as it often not feasible for businesses to keep the cash for long periods of time.

Leading and lagging: This is really a gamble based on ‘gut feel’ or ‘hunch’. Leading is when you anticipate that a foreign currency will strengthen against your home currency. You then buy this foreign currency in advance. I exchanged £2,000 into Euros just over 2 years ago when the exchange rate was £1:€1.4. Since then, Europe has been my holiday destination of choice as I have the Euros; more importantly I don’t have to worry about the current adverse exchange rate (£1:€1.1). This was not based on any science and it could easily have gone the other way. If that was the case I would not be as happy sharing the story with you! 

Lagging is the exact opposite. Lagging is when you anticipate that a foreign currency will weaken against your home currency. If I had thought the Euro would go in my favour, then I would have delayed buying Euros until the point I was actually going on holiday. If I’d taken that gamble then my holidays to Europe would be more expensive.

Forward exchange contracts: A forward exchange contract is a binding agreement to sell (deliver) or buy an agreed amount of currency at a specified time in the future at an agreed exchange rate (the forward rate).

Money market hedging: Say a UK manufacturer exporting to the US is due to receive US$2m in three months time. However, the business does not have any US$ liability to settle. What it can do is to create a liability that will soak up the US$. It can do this by creating a US$ liability by borrowing US$ now and then repaying that in three months with the US$ receipt.

Currency futures and options: These are often used to mitigate currency risk.

Currency futures are items you can buy and sell on the futures market and whose price will closely follow the exchange rate.

Options are different – they give the holder the right but not the obligation, to buy or sell a given amount of currency at a fixed exchange rate in the future. The right to sell a currency at a set rate is a put option; the right to buy the currency at a set rate is a call option.

Economic risk:

Economic risk is caused by the effect of unexpected currency fluctuations on a company’s future cash flows and market value. Unanticipated exchange rate fluctuations can have a substantial affect on a company’s competitive position, even if its exposure is restricted to domestic markets. For example, a UK manufacturing company still has to contend with cheaper imports from Asia, which may get cheaper and more competitive if sterling strengthens significantly.

Mitigating this risk for small companies with limited international exposure is difficult. Some pointers to help mitigate the risk:

Have customers and suppliers in the same overseas company. Have a bank account in that currency and invoice your customers in the foreign currency; ensure customers pay in that currency, which in turn you can use to pay the supplier.

Manufacture your goods in the country in which you sell them. Although raw materials might still be imported and affected by exchange rates, other expenses are in the local currency and not subject to exchange rate movements.

Conclusion:

As the world becomes ‘smaller’ and international trading becomes the norm for businesses of all sizes, it’s inevitable that to remain competitive you will have to confront foreign currency issues. It is wise to start planning for the risk to your business and to consider what policies you have in place to mitigate your exposure. Larger companies will have dedicated finance teams to deal specifically with foreign currency transactions. Smaller companies do not have this luxury due do budgetary constraints. Yet, to remain competitive, they need to pay just as much attention to currency fluctuations. I recommend that if you do not have access to in house expertise, you speak to your accountant who may be able to help you or point you towards a foreign currency specialist, depending on the complexity of transactions.

If you would like to discuss the effect of foreign currency risk on your business or any other business related matter please contact me for advice.