International Trade eLearning Suite for SMEs-InTeLS
Foreign currency and exchange risks
1.1.1 Introduction
If your business exports or imports goods or services, you need to consider how you will protect yourself against changes in the exchange rate. A tiny variation in the rate could cost your business thousands of pounds.
You'll also need to decide how to make and receive payments in foreign currencies.
This guide is aimed at businesses which regularly deal with foreign customers. It explains how to price goods or services, how to combat the risk of exchange rate changes and the practicalities of dealing in foreign currencies.
1.1.2 Foreign currency issues when importing or exporting
Businesses which import or export goods need to bear in mind a number of key issues when making transactions in foreign currencies.
- Foreign currency transactions are sensitive to fluctuations in the exchange rate. A price you agree with a customer or supplier on one day could rise or fall if the exchange rate changes. But there are steps you can take to protect yourself against these..
- If you're exporting, you must decide whether it's best to price your goods or services in the local currency of the country with which you're trading. The decision will depend on individual circumstances and on factors such as how you want to present yourself in that market and how your competitors set their prices.
- If you're importing components priced in a foreign currency that form part of goods you're selling in sterling, you'll need to decide how to price those goods to reflect the exchange rate.
- If you are trading with companies in the eurozone there are many practices and standards to make life easier.
You can find information on pricing your products or services for foreign markets on the SITPRO website.
See our guide on Trading in the European Union.
1.1.3 Identify foreign exchange risks
When your business deals in a foreign currency you are exposed to certain risks.
For example, you might find that after agreeing a price for exported or imported goods the exchange rate changes before delivery. Clearly, this can work both for and against you.
Some countries' currencies are more volatile than others because of their inflationary or unstable economies. This makes their exchange rates more liable to extreme movements. Your bank should be able to advise you.
Of course, because exchange rates can go both up and down, it can be tempting to gamble that this will work out in your favour. However, this is extremely risky and could land you with a significant financial loss.
It's safer to reduce the risk by using one of the forms of hedging available through a bank. Hedging simply means insuring against the price of an item - in this case, currency - moving against you in the future. Three types of hedging are discussed in this guide.
You could, of course, consider trading overseas in local currency - effectively transferring the foreign exchange risk to the business you're dealing with. Whether this is an appropriate solution will probably depend on the product in question and the relative bargaining strength of you and your trading partner.
Bear in mind that exchange rates could have an effect on your business' competitiveness even if you don't trade overseas. When a country's currency loses value against your local currency, imports from that country into your country become cheaper, so you may have to respond to aggressive pricing from competitors who source from that country.
Similarly, if a country's currency gains against your local currency, national exports to that country become cheaper.
See the pages in this guide on opening foreign currency accounts and buying currency options
1.1.4 Forward foreign exchange contracts
One way to hedge against exchange rate movements is to arrange a forward foreign exchange contract. This is an agreement initiated by you to buy or sell a specific amount of foreign currency at a certain rate, on or before a certain date.
Forward foreign exchange contracts are a secure and simple way of hedging when you're confident your deal will go ahead and the currency will be required.
Imagine you will need to purchase components worth €100,000 from a German supplier in 12 months' time. One euro might currently be worth 60 pence, meaning the supplies would theoretically cost £60,000.
However, if the euro increases in value to 67 pence over the year, they would cost you £67,000.
If the euro is expected to increase in value, you might agree a forward foreign exchange contract to buy €100,000 for £62,000 on a specified date. Of course, you'll lose out if the euro falls in value.
This option suits businesses that:
- trade in a volatile market or to tight margins
- require large amounts of currency in relation to turnover
Advantages
- You're protected against any adverse movements in the exchange rate.
- You can set budgets knowing exactly how much the transaction costs.
Disadvantages
- You have to go ahead with the contract once you've arranged it, regardless of whether your circumstances change.
- Because the rate is fixed, you can't benefit from any favourable movement in the exchange rate.
Forward foreign exchange contracts can be arranged through all the major clearing banks in your country and can be tailored to meet your specific requirements. Your bank should be able to advise you.
The cost is generally built into the exchange rate you get, so no other fees are payable.
Read about forward foreign exchange contracts on the SITPRO website.
1.1.5 Opening foreign currency accounts
An alternative way of hedging your currency risk is to open a foreign currency account - a bank account operated in your own country in a foreign currency of your choice.
Foreign currency accounts can be a good option for importers and exporters.
If you open an account in the currency in which you make the bulk of your transactions you can hedge against exchange rate changes by keeping money in the account until the rate is beneficial to you.
Although not all European countries are in the eurozone, you may be able to open a euro account in your own country - which could be useful if you conduct a lot of business with other European customers. It allows you to hedge risks for a range of EU countries at the same time.
This option suits businesses with:
- a large number of dealings in a particular currency
- a strong cashflow - which means they're unlikely to require immediate access to funds
Advantages
- Ease of access.
- Potential interest earned on your deposits.
- The ability to discuss transactions in your own language with your own bank.
- Avoiding the cost of exchanging currency.
Disadvantages
- There will be charges for setting up and running the account.
- If you need to convert funds in your foreign currency account into local currency for national use, you will face a loss if your local currency is strong against that currency.
- You may also have to wait a long time for the exchange rate to move in your favour - and it may never do so.
Foreign currency accounts can be a good option for importers and exporters. They are offered by most of the
1.1.6 Opening an account with a bank overseas
A common alternative to opening a foreign currency account operated by a national bank is to open a bank account in the country with which you're trading.
This option suits businesses that make or receive lots of payments - especially small payments - in a foreign currency.
Advantages
- Because your money will be held in the local currency you can wait for the exchange rate to become more favourable before converting it - as long as you don't need the funds immediately.
- A bank in the country with which you're trading will also be fully conversant with the rules and regulations regarding transactions in that country, and your customers might prefer to deal with a bank in their own country and in their own language.
Disadvantages
- You may experience communication difficulties that can't be remedied face-to-face - which wouldn't be the case with a foreign currency account in your own country.
- Depending on the country in question, there may be complex rules governing who is entitled to open and operate a bank account.
- Procedures to stop money laundering may mean that setting up such an account is a long-winded process requiring many stages of legal and administrative clearance.
- Overseas banks may not offer the same level of redress and protection as national banks.
1.1.7 Buying currency options
Buying currency options is a more flexible form of hedging than setting up a forward foreign exchange contract - but it's also more expensive.
Currency options give you the right, but not the obligation, to buy a certain amount of currency at a specific exchange rate on or before a specified date. But unlike a forward foreign exchange contract, you're not obliged to buy the currency at the end of the period.
To enjoy this flexibility you'll have to pay a premium, which typically might be a minimum of £500. (650 euros) The exact amount will depend on the amount of currency involved and the length of the option.
This option suits businesses that:
- want to protect themselves from unfavourable rate changes while retaining the flexibility to benefit from advantageous ones
- are entering into a deal and there's a fair chance of it not going ahead
Advantages
- You're protected from any adverse movements in the exchange rate.
- Your business can benefit if the exchange rate moves in your favour.
Disadvantage
- The expense of setting the option up.
The ability to buy currency options is offered by most clearing banks.
1.1.8 Foreign currency transactions and your bookkeeping
Carrying out business transactions in a foreign currency will have an effect on your normal accountancy procedures since you'll need to convert foreign currency payments and deposits into your local currency.
Accounting procedures are complex and you should take professional advice on your own circumstances. Generally speaking when you account for foreign currency transactions you should calculate the amount in local currency, using the exchange rate that applied on the day of the transaction.
Any foreign currency held, as well as any amounts of currency that you owe or are owed, should be converted into local currency using the rate in force on the date of the balance sheet.
If you make any gains or losses as a result of foreign currency transactions, you should include these in your profit and loss account.
Bear in mind that holding assets in a foreign currency will have an impact on your balance sheet since - owing to exchange rate movements - their value might differ radically from one year to the next.
You can find details of past exchange rates on the Exchange Rate website