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Managing currency risk

News & Resources · 5 min read

Managing currency risk

For importers, a rapid change in the value of the dollar can turn your profits into losses. But there are ways you can manage that risk.

Our manufacturers may be lamenting the strong dollar, but for the past few years, importers of foreign goods have been blessed by a consistently buoyant Australian dollar; allowing them to bring in products that might once have seemed prohibitively expensive and uncompetitive against Australian-made products on the local market.

Tony Busuttil is one such importer. He and his wife Lisa have a passion for European quality—particularly gourmet foods, but also fashion, jewellery and homewares. They started their business Simply European two years ago, riding the wave of the strong Aussie dollar, which has been favourable ever since.

 “We deal mostly in Euros, obviously,” says Tony. “So currency has never been a major issue since we’ve been in business. But there seems to be more global instability on the horizon, which has required us to be more diligent in managing our currency risk, along with some of the other risks for businesses like ours.”

Business profile helps define risk

Foreign exchange risk is the possibility of balance sheets or profitability in a business being adversely impacted by fluctuation in foreign exchange rates. Of course, trade-exposed export industries such as mining and manufacturing face the inverse problem—that the strong Australian dollar is making our product output (and labour) too expensive abroad.A sudden movement in exchange rates can strip thousands from a pre-existing order

For importers, particularly small importers, exposure to foreign exchange risk occurs when business is conducted, wholly or in part, using a foreign currency—whether this take the form of foreign loans, purchasing or selling capital equipment using a foreign currency, assets purchased or held overseas and any form of foreign currency income, for example, interest receipts, dividends or royalties.

A sudden movement in exchange rates can strip thousands from a pre-existing order—particularly if, as is not uncommon, businesses pay their invoices weeks or even months later than they take receipt of their shipment.

Currency-exposed businesses face a risk in any climate, says Simon Coxhead, currency dealer at Direct FX, an NZ-based company specialising in currency trading, because the markets move randomly at times and are particularly flow-driven in the short term: “Demand or lack of demand on any given day can have a material effect on the price action of any currency,” he says. “Obviously if the dollar is high it is beneficial to margins, but any fall before a rate is locked in still comes directly off the bottom line.”

Small businesses that are trade-exposed in this way can shield themselves from the negative impacts of global currency movements by hedging some or all of their exposure to foreign currency. “Decisions need to be made at the time after considering various factors, not least of which is cash flow. Often these decisions will have to be made on a case by case basis,” says Simon.

Step-by-step

Gavan Ord, Business Policy Adviser at CPA Australia, says there are a number of preliminary steps that should be taken by any small business to assess exposure and what action to take, if any.

“The first step is to determine if your business has a foreign currency risk exposure, which importers obviously do,” he says. “Then you should take steps to measure that risk and, thirdly, consider the different ways of managing that risk.”

Gavan suggests considering a sensitivity analysis—a business needs to assess how much it stands to lose in a given change scenario. “So if the exchange rate declines by 20 per cent, how much would that impact upon the business,” says Gavan.

“You could take that a step further and do what is called a ‘value-at-risk’, where you ask what the probability is of a 20 per cent decline. This is more complicated, and many smaller businesses wouldn’t take this extra step. But at a basic level businesses need to ask themselves if they are happy to live with that risk.”

If an importer is also dealing with commodities, for example, coffee, wheat or cotton, there’s an extra layer of risk, because commodity prices fluctuate independently. If it is a particularly risky sort of product, the risk is compounded and the two risks are not necessarily linked. This adds to the complexity of a business’s risk planning. Small margins can cause a significant impact on the bottom line.

Once the risk is identified—and you decide you want to act on the risk (some businesses with only a small import exposure may feel the risk is not worth managing).

There are various hedging methods you can use:

1. Pay the invoices up front.

This does introduce a cash-flow risk, but it does provide some price certainty. Businesses may, understandably, be unwilling to pay for a product they have yet to receive.

2. Execute a forward exchange contract.

This is where the importer agrees on a certain rate in advance, which will be paid upon receipt of the product. These contracts are common and useful, but their disadvantage is that a business will be locked into a rate in the event that the rate becomes even more favourable for importing at the time of delivery. To avoid being locked in, you might consider a foreign currency option, which allows you to take advantage of a positive exchange rate movement. There is a high premium often involved in taking this step. Banks and foreign exchange specialists often broker these deals, and it is important for small businesses to engage experts if they are concerned that too much of their business time will be taken up in ‘playing’ the currency market. “Where there is no benefit in buying currency early, for example in being able to pay early to achieve discounts, or where cash flow is tight, importers should consider ways to protect themselves by either buying currency forward or using option and option structures to help manage these risks,” says Darren Heathcote, Head of Trading at Investec.

3. Keep an account in foreign currency.

Another option for small businesses that trade regularly in a certain foreign currency is to keep a bank account in that currency. Of course, there are cash flow implications with this method, and small importers whose revenue is assessed in Australian dollars will still, eventually, have to change these funds into Australian currency, though they may be in a better position to pick their timing.Gavan cautions that risk management can become an end in itself, to the detriment of your business. “Your focus should be on your business, and not on watching the exchange rates every day and waiting for the right day. Some people get caught up in managing their risks too closely, to the point where they lose focus on their business. “It’s important for importers to understand that they are in the business of importing to sell goods and services, they are not foreign exchange speculators. They should know the options available to them, but we would encourage them to speak to their foreign exchange providers about the detail.”

For small business owner Tony, himself a Certified Practising Accountant, it’s a matter of deploying a combination of tactics. “I monitor the exchange rate fairly closely. We’ve also diversified the product mix to include more Australian products where possible and appropriate for our business—for example, locally made chocolates by a Swiss Italian chocolatier.

“Of course we also use forward exchange contracts to provide us with a degree of certainty, and to enable us to set up unit costs and pricing in advance. This allows us a buffer for exchange rate variations.”

As with all business decisions involving risk, it is important to seek independent advice before you proceed. “We would always recommend that organisations spend time analysing their business and the foreign exchange risks and using the options made available to them, draw up a hedging protocol that clearly sets out how they should manage these risks,” says Darren. “There are many independent local organisations that can help them with this aspect of planning.”

FOR MORE INFORMATION
Direct FX
CPA Australia
Investec’s solutions for hedging currency risk

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