How to Mitigate Currency Exchange Rate Risks and Fluctuations
- Currency exchange
Exchange rate risk can have a serious impact on your business. If your home currency appreciates against the foreign currency you sell your products in, you could lose a great chunk of your profits. Luckily, by mitigating your foreign exchange risk with best practices, you can make foreign trade and international money transfer much more predictable.
How does exchange rate risk affect SMEs?
Exchange rate risk (also called foreign exchange risk) affects your financial performance due to fluctuating exchange rates between different currencies. There are 3 major exchange rate risks: Transaction risk, economic risk and translation risk.
- Transaction risk: Transaction risks typically occur if you conduct business in another currency and have therefore the obligation to make or receive payments in a foreign currency. For instance, you are based in Switzerland and buy machinery in China. Upon signing the purchase contract, 72’584 Chinese Yuan equal 10’000 Swiss Francs. When paying your supplier 3 months later, however, the same amount equals 10’500 Swiss Francs, which means, you effectively paid more.
- Economic risk: While transaction risk affects actual cash flows, economic risk refers to a long-term strategic risk indirectly affecting future cash flows and market value due to fluctuating exchange rates which have their cause in unexpected macroeconomic or political changes. Because of its unexpected, long-term nature, economic risk is more difficult to quantify and hedge.
- Translation risk: Translation risk occurs if your company’s performance is denoted in your domestic currency while you own assets, liabilities or equities in foreign currencies. The more you hold in a foreign currency, the bigger your exchange rate risk becomes.
Ways to hedge against foreign exchange risk
There are many ways a business can hedge against exchange rate risk, among the most common are forward contracts and currency options but also currency ETFs and foreign exchange rate alerts.
- Forward contracts: Forward contracts allow a business to buy or sell a specified amount of foreign currencies at a fixed price on a future date. Forward contracts can be fully customised for the amount and delivery date. Therefore, when setting up your forward contract, you know exactly how much you will pay in the future for the foreign currency, which makes the currency exchange more predictable and reduces your exchange rate risk.
- Currency options: Options work like forward contracts, except for the fact that contracts are an obligation to buy or sell while currency options provide the right to buy or sell a currency at a specified exchange rate on or before a specified date. As the buyer or seller receives a right but not an obligation, a premium is charged.
- Currency ETFs: While forward contracts and currency options are the most common way to hedge against exchange rate risk, small businesses might not have the time and capabilities for it. As an alternative, currency exchange-traded funds can mitigate the foreign exchange risk for SMEs and retail investors.
- The amnis fx rate alert: If you want to get foreign currencies at the best possible rates, you can make use of the amnis fx rate alert tool. This tool enables you to receive daily or custom alerts once the currency pairs hit your target rate. A perfect tool for companies to keep an overview of the exchange market and its fluctuations and reduce exchange rate risk.
Best practices: Hedging with Forward Contracts
Forward contracts belong to the most commonly used instruments when it comes to hedging against exchange rate risk. When entering a forward contract, you will know exactly how much your needed foreign currency will cost at a specified date. Therefore, forward contracts eliminate the transaction risk.
Example: If you own a production company in Switzerland and your customer will pay you in USD in 6 months, it is crucial to hedge against the possible depreciation of the USD to your home currency, as this would directly impact your profit margin.
In order to know your profit margin already at the day your contract is signed, you can set up a forward contract. In this contract, you agree to sell the same amount of USD in 6 months’ time, so at the time your customer will settle his invoice with you. By doing so, you can effectively hedge against a great deal of the exchange rate risk.
Some providers, like amnis, also offer the possibility to adjust the value date of a forward contract. This means that in case of a payment delay, you can simply change the value date and adjust it to your currency needs. Hence, you get the flexibility to execute the forward contract only once you have actually received the USD from your customer and are ready to sell them against your home currency.
Hedge against exchange rate risk to gain a competitive advantage
Hedging against foreign exchange risk is an important instrument to bring transparency and predictability to your financial processes. It allows you to plan with confidence and even to profit from currency changes if you choose the right instruments.
amnis combines all the tools you need for optimizing international money transfer and foreign currency exchange. You can send and receive international payments without any hidden fees, trade foreign currencies at transparent rates and manage your exchange rate risk effectively. Moreover, bank opening hours no longer play a role. You can access the amnis platform whenever you want and exchange currencies even on weekends – 24/7. Create your free demo account, it only takes 30 seconds, and test all WebApp functions completely non-binding: