28 September 2015
Companies looking to increase export activity will be exposed to risk on the foreign exchange market
The British Government, business groups and companies of all sizes are in agreement that Britain needs to export more if it is to grow sustainably. The companies that answer that rallying cry will be directly affected by the foreign exchange market and all that it entails. Managing foreign exchange (forex) risks and ensuring continued success overseas is a challenge but it is certainly not insurmountable. Simple steps will make all the difference.
The government’s aim to boost exports is a challenge. With £450 billion of goods and services arriving in 2014, Britain is the world’s fourth largest importer – so for Britain to become a net exporter would take a monumental shift in demand and dependencies. There is however plenty of room to balance up the trade deficit and the signs so far are good: 57% of British companies are currently exporting and that has risen by 10% since 2010. HMRC statistics show that the value of those exports rose by 8% in the year to April 2015.
The risks associated with forex can be daunting unless companies are prepared. In an ideal world every company would have a treasury team to monitor exchange rates, assess trends, review the fundamental analysis and use all of that information to hedge the company’s exposure to forex fluctuations. For the vast majority of UK businesses – not forgetting that the Federation of Small Businesses reports that 99.3% of all UK companies are classified as small businesses – such an arrangement would be overkill or unjustifiably expensive. However, managing the risk has to fall to someone and that someone is generally the head of the company’s financial affairs.
It is worth considering some statistics to put foreign exchange volatility into context. In the first six months of 2015, the Sterling–Euro exchange rate moved by 12.5% from the low in January to the June high. In the same time frame, the Sterling–US Dollar rate displayed a range of 10% between the $1.45 low and nearly $1.60 high. The Sterling–Swiss Franc range, following the Swiss National Bank’s unpegging decision (removing a link between the Swiss Franc and the Euro), has swung by some 25% and is currently sitting roughly 6.5% below the high of the year. When many companies are working on single digit profit margins and some are relieved if they post 2 or 3%, inexperience or looseness in the finance department’s currency management can wipe out all the hard work put in by the marketing, sales and distribution departments. Poorly managed forex needs may even render that hard-won international trade agreement entirely profitless or make the recently published price list redundant – this could threaten the viability of an entire business model.
The necessity to manage the danger associated with those fluctuations can be a surprisingly loose affair. Even companies with years of cross-border trade under their belts can find foreign exchange management a headache. Some even avoid the need to understand the nature of that risk, preferring instead to leave all currency conversions until they are unavoidable – for example, when the invoice is due for payment or when the inward funds are received.
The adage of ‘win some lose some’ is regularly used in such circumstances and this head in sand style of forex management is even described as ‘risk-averse’, usually without any hint of irony. However, the consequences of delayed risk management can be dire.
The key to good currency management is planning. When that planning takes place can be subject to the nature of the business, the timelines through the supply chain, projected timespans or, as is often the case, customer pressure.
In an ideal world, that planning would start well before any project was implemented. Decisions made at the costing and budgeting stage are often based on a gut feeling or guesswork but resorting to reliable chartist projections is, more often than not, the most effective baseline tool. A projected trend line which prices in all the ‘known knowns’, as Donald Rumsfeld would have put it, is a reasonably reliable guide. Some contingency needs to be built in for the ‘known unknowns’ but no one can mitigate for a Swiss National Bank type of event. Those are once in a decade affairs – although if you add in the credit crunch in 2007/8, then we have had two major events in a decade.
Being prepared for the risks that those sorts of events pose is relatively straightforward. If a company needs to be able to convert their Sterling into Euros at €1.35 for example, then the use of options, forward contracts or automated stop loss market orders will all do that for them.
Options confirm the right to buy a specified amount of currency at a predetermined exchange rate but the company is not obliged to do so. Hence, they can participate in any interim beneficial exchange rate movement. The negative is that options either cost a premium which has to be factored into the cost calculations or they come with caveats which may include penalties for excessive market movement. Caveat emptor applies and a finance director getting involved in options needs to know all the ramifications before signing on the dotted line.
A forward contract allows the company to set a firm exchange rate for a fixed contract for settlement at an agreed future date. That entirely removes the risk of the market slipping away to lower levels but does not allow the company to participate if the exchange rate improves. If risk management and having a firm cost price to work from is the main priority, then a forward contract is a definite opportunity.
Automated orders are now more frequently used through specialist brokers. From a risk perspective, stop loss orders do exactly what they say on the tin. They set a predetermined worst case exchange rate at which the order will trigger and a contract will be automatically booked. If the order is never triggered, it can be altered in the rate or the amount. They are often raised behind positive market movement to lock in further gains. Alternatively, if the exchange rate movement is very positive or the payment date is looming, the order can be cancelled and the company can trade at the prevailing market rate. That flexibility has proven to be popular.
Good governance of currency requirements makes financial reporting far more accurate. For future requirements that are covered by some form of hedging tool, the GP and ROI data is almost set in stone. Those with an open book of unhedged commitments do not have that certainty. This affords all stakeholders the benefit of clarity and elevates the profile of those who are managing the risk.
Foreign currency management is not just about trade; increasing numbers of companies employ overseas staff. That may be the call centre in Mumbai, the tech team in Korea, the finance team in Ireland; all involve some element of currency exposure and all produce a risk that can be managed. Where there are regular ongoing costs or receipts, it is possible to use forward contracts in monthly drip feed patterns to ensure a fixed exchange rate and therefore a fixed cost. That same approach can be used for salaries; having a fixed monthly Sterling costs against a fixed monthly USD salary payment is a very attractive option, especially when Sterling is trading at six-year highs in some currency pairs. Equally, where there are regular receipts from rental arrangements or fixed monthly deliveries, those same fixed rate arrangements provide certainty of the GBP value of that income without the disruptive exchange rate fluctuations.
Ultimately, effective currency management is just an element of good governance. It provides a degree of certainty, continuity, protects against shocks and disruption and can give confidence to those who need to know the company is in good health. Making use of the tools available to all businesses is simply a matter of applying sound commercial thinking and responsible risk-aversion – and that should be the basis of all governance.
David Johnson is Director at Halo Financial