David Johnson, a director of Halo Financial, a London-based currency exchange brokerage, talks about the importance of successful foreign currency management
Travel is by definition a global business and for any firm with overseas dealings, one measure of success is how well it handles foreign currency management. As anyone watching the slide of sterling in the run-up to, following, and beyond the Brexit vote will have noted, prices of imports have risen and purchases made on the continent are now much more expensive.
Whether it is fuel, tyres, driver and passenger accommodation, a booking made now for later payment can become markedly more expensive if the exchange rate swings the wrong way. It’s a point noted by Travel Weekly in 2011 following the last economic crisis. It said: “Tour operators who have not hedged their foreign exchange rates effectively are feeling the financial strain.”
So what steps can a firm take to protect its exposure to currency movements? There are undoubtedly all manner of ways to complicate things, and while there are as many variations on hedging products as there are permutations on a lottery ticket, there are also some straightforward steps that every business can take to protect themselves.
Planning
A conversation about currency risk generally starts with a real exposure but, as soon as you start planning a year involving foreign exchange exposure, there are opportunities to mitigate the risk. This is less straightforward for newer businesses, where forecasts can rely on an element of guess work. Where this is the case, caution is the key and an over-commitment to foreign exchange hedging can be as much of a hassle as a remedy. Covering known requirements is most often the better option. Gambling on exchange rates and anticipated trade volumes can be a recipe for disaster, but there are risk management tools which can be explored.
Anyone who claims to be able to pinpoint exactly where an exchange rate will be at a certain point in the future is deluded. A market with millions of participants which transacts $4tn a day is not something which can be forecast with any level of certainty, but technical analysts and economists usually provide details of expected exchange rate ranges over any time scale.
Having good currency information will give you the opportunity to set your cost levels, prepare your brochures or publish pricing to customers. It also helps with longer-term tenders and project planning.[wlm_nonmember][…]
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Managing risk
If you are entirely risk averse, as soon as you have an identifiable currency risk, you might choose to purchase all of your currency requirements. If cash flow allows, you may wish to do that and hold the proceeds of the contracts on currency accounts pending payment requests. Thus you will have removed exchange rate variation from your planning and have the flexibility of cash at hand in the correct currency when you need it.
However, for many, cash flow doesn’t allow for that and this is the more likely scenario. You can still cut all risk through the use of ‘forward contracts.’ These allow you to use today’s exchange rate upon which to put a contract in place but delay the final settlement of that contract for up to two years. This generally requires you to lodge a part payment / deposit initially but it aids cash flow by keeping the bulk of your funds available as working capital.
The other advantage of forward contracts is that, if payment is required more urgently or if the payment needs to be delayed, the forward contract can be flexed to either draw down for early delivery or extend (roll over) to a late settlement date, if necessary. This may vary the exchange rate you receive, because forward contract exchange rates are adjusted for the differential between the interest rates in each country. However, with most countries having very low interest rates at the moment (but there are suggestions that they could rise soon), those adjustments are generally rather small and the advantage of the flexibility that a forward contract affords is often worth that minor hassle.
Many companies find that forward contracts are the tool of choice for payment of invoices on 30, 60 or 90 day terms, as they provide exchange rate certainty for the whole credit period. Forward contracts are also used where goods are received on consignment or where letters of credit are required.
If the exchange rate is moving in your favour and you want to wait to see if there is some advantage to be taken from that trend, there is nothing to stop you from protecting against exchange rate risk. This adds some level of certainty just in case you have misunderstood the market mood or if the unexpected happens.
A ‘stop loss order’ (SLO) is the perfect tool in these circumstances. An SLO is placed into the foreign exchange market with a market maker to guarantee a minimum exchange rate. The order sits as a latent instruction but isn’t actioned until the market moves in such a way as to trigger the order. So, for example, if you need to buy euros and the current market exchange rate is €1.12 but the trend looks like it is heading higher, you may be tempted to wait for a better level. Obviously, the ever-present risk is that the trend changes and the pound slumps through to €1.03, wiping out your profit.
Let’s also assume you cannot make a return on your contract unless you can achieve at least €1.05 or better. In these circumstances, you could place a SLO at €1.05 to guarantee that rate as your worst case scenario while leaving the opportunity to buy at higher levels if the pound continues to rally. These sorts of automated market orders have been used by speculators for decades but are the perfect tool for companies in need of certainty in an uncertain world. Essentially, even if the pound collapsed, as soon as the sterling-euro exchange rate fell to €1.05, your order would be triggered and you will have bought your currency.
There is another alternative to the SLO – ‘options’. These are used by many companies, especially where they have sizable requirements and/or long-term deals. However, they can be expensive because plain vanilla options, as the basic form is termed, require the payment of a non-refundable premium yet they serve the same basic purpose as an SLO; that of guaranteeing a minimum exchange rate. The flexibility in an option is that you do not need to exercise the right to buy at the option level unless you want to. Some more complex option packages carry no premium but, where that is the case, there is always a downside to the option plan. These are sometimes referred to as ‘Structured Products’ and you should be very clear about the catches if you take on an option of this sort.
Using volatility
Automated orders can be used in another way. A ‘limit’ order can be used to target an advantageous exchange rate which is above the current level. On this point, it is worth being aware that the foreign exchange market doesn’t rest. Trading begins on Sunday night UK time and continues around the clock until the US markets close on Friday night. One by-product of this 24/6 action is that some of the most volatile periods occur when individual markets are opening or closing. If you are based in the UK and you manage your currency transactions through a high street bank, you miss all the opportunities that happen after 1730hrs and before 0830hrs the next day as they are outside of UK banking hours. Within that period, New York has closed, Asian markets have opened and closed, Australasian trading desks have opened and closed, the Middle Eastern markets have opened and so has Europe.
You can capture the volatility by placing automated limit orders at pre-determined exchange rates. As long as the market trades to your nominated level, your order will be filled and you can then decide whether to settle on a spot or forward contract.
Good brokers will also watch orders for you.
How to pay
Consider whether you want to get a broker to make your payments for you or whether you would prefer to accumulate currency in your own foreign currency account and manage your own payments. The upside to holding currency accounts is that it affords you more flexibility, but there are some minimal costs associated with maintaining all business accounts. Overdraft interest rates on currency accounts can also be prohibitive so it is worth researching that before you go ahead.
You may consider it useful to hold accounts in the countries in which you are operating, have expenses or are sourcing goods. Many bank portals allow you to manage overseas accounts so that is certainly worth asking your bank manager about.
When it comes to payments, there are many options these days. Payments within Europe are cheaply and quickly delivered through Single Euro Payments Area transfers. Check whether there will be receiving fees for payments made in this way or through wire transfers in Europe. Some banks – most notably in Spain – can be extraordinarily expensive when they receive funds into accounts through international transfers. It is very worthwhile checking before you make a payment of this sort and you are likely to find that payments below €50,000 tend to be more fairly treated, even by Spanish banks.
Other international transfers are most often paid through TT or wire transfers and sterling payments within the UK can be made quickly and cheaply through the new Faster Payment System.
Planning, planning, and planning
To a large extent, planning is the key to every aspect of success in managing your currency needs. If you ask all of your questions in advance, dot all the i’s and cross all the t’s, you will suffer fewer shocks and avoid nasty surprises.[/wlm_ismember]
