How to protect your business from exchange rate fluctuations: step-by-step instructions
In any activity, especially in business, situations regularly arise when an increase in the exchange rate or its decrease destroys all the plans of the entrepreneur. For example, when working with foreign suppliers, you plan to conclude a supply contract at one price, but a jump in the currency means that you will have to pay at a completely different price. Because of such situations, transactions can become as unprofitable as possible, and the business will suffer regular losses.
How much easier it would be if you knew exactly how much a dollar will cost in a month, then you could accurately plan the financial result. This is quite possible if you use derivative financial instruments that can protect against a jump in the exchange rate. They can be effectively applied in businesses of any size. Such a strategy can be useful for both a large enterprise and a novice individual entrepreneur.
To protect against fluctuations, it is necessary to fix the dollar exchange rate
For example, your company wants to buy raw materials or products from a foreign supplier in a month, for which you will need to pay $ 2000, while buying currency for hryvnia.
If you buy currency at the current price in advance, you will have to take the required amount out of circulation, which is not always reasonable. Another option is to buy it in a month at the time of payment for delivery, however, if the value of the dollar decreases, buying currency will cost more. In other words, your company is at risk of losing money due to a lower exchange rate.
To reduce currency risks, a firm can contact a banking organization and report that it will need $ 2,000 in a month. The bank, in turn, will offer you the exchange rate at which you can purchase currency in a month. If you are satisfied with the bank’s offer, you will enter into an agreement, and the required amount of currency will be fixed for you.
No matter how the exchange rate changes during this month, the bank will sell the agreed amount exactly at the price that was fixed for you.
In the process of concluding a transaction, all its conditions are recorded – the amount, currency, term, price. In practice, such a transaction is called a currency forward contract, it can be a settlement or delivery contract.
In the first case, the currency is not delivered, and one of the parties pays the difference between the exchange rate fixed in the contract and the market rate at the time of settlement on a specific settlement date for the concluded transaction. Such transactions are usually used when the delivery contract specifies that the price depends on the exchange rate of the National Bank of Ukraine.
Delivery forwards involve the delivery of currency under contracts. Instruments such as options are often used to reduce currency risks. They are also able to capture and prevent the undesirable consequences of unexpected currency exchange rate jumps. Using this option, the entrepreneur gets more freedom.
When entering into a forward transaction under its terms, the company must purchase foreign currency from the bank after the agreed period. If the option is purchased, the firm may refuse to buy foreign currency from the bank at the fixed exchange rate, if, for example, the hryvnia has strengthened its position.
Using such tools, it is necessary to understand that options and forwards are not a way to speculate on the currency market, first of all, these tools are aimed at simplifying the financial planning of an organization. They make it possible to conduct business calmly, and not in conditions of constant uncertainty, while keeping the dollar exchange rate jumps within certain limits.
Currency futures operate on the principle of an option, its main difference is that you will not be able to cancel the contract. Futures are considered a riskier instrument than, for example, an option.
When building their business on foreign currency, entrepreneurs need to understand that the market rate in a month may be more profitable than what was fixed by the forward, and this is normal. There is no way to predict all the jumps in advance, you fix the dollar exchange rate, what to do in this case is already clear, not in order to earn or lose something, but in order to make the result of a future transaction as predictable as possible.
If your activity involves the use of foreign currency funds, please remember:
- you will not be able to influence the currency change, but you can use the existing opportunities to protect yourself and your company from currency risks.;
- it is recommended to use this protection only if the dollar exchange rate affects a large part of your profit and there is no risk of wasting your money.;
- if you decide to hedge, that is, protect risks with forwards, options, etc., you should choose the most profitable option with a minimum of obligations on your part;
- hedging risks on the stock exchange trust only the broker, choose it carefully and check the availability of a license.
Using such financial instruments, you can not only win, but also lose, so you need to do it as carefully as possible and check every step you take.
How to take control of the dollar exchange rate, what to do?
Experts recommend using some tips in the process of planning a hedging strategy and protecting your business from currency risks.
First, evaluate your business for the presence of currency risks due to currency depreciation. Such risks are possible if the company has expenses in one currency and revenues in another. In this case, the financial result of transactions may change due to a jump in the currency.
The company has certain currency risks if you have:
- income and expenses are not in your local currency;
- contracts and payments in UAH, the volume and value of which depend on the exchange rate at the time of payment;
- loans and borrowings in dollars or euros.
Having identified all possible risks and their dependence on the exchange rate, make a detailed schedule of receipts and payments in foreign currency.
If you understand that certain risks are present in your company, you need to carefully study them. You should clearly understand when and to what extent you will need foreign currency to pay bills to suppliers and contractors, what date you need to change the currency to rubles, and think about fixing the dollar exchange rate.
When there is a detailed schedule of payments that are subject to currency risks, they will be easier to prevent and reduce. To do this, you will need to develop an effective strategy.
In some cases, it is not necessary to immediately choose financial instruments that can protect against currency surges. Sometimes it is more profitable and appropriate to shift currency risks to your suppliers or buyers, for example. There is always an opportunity to negotiate with counterparties, if it does not work out, you can raise prices for buyers.
The easiest way to protect your business from currency fluctuations is to buy goods in your own country, but this solution is not suitable for everyone. You can also try to sell your product in those markets that allow you to sell it in the same currency that you purchased it for. In addition, a part of a batch of goods purchased for foreign currency can be sold to another country, thereby protecting yourself from currency appreciation, and the other part can be sold in your home country, additionally protecting it with financial instruments from currency risks.
Each business has its own specifics, so strategies are created individually. If you still decide to choose tools to reduce risks, for the first time it is better to use a forward that allows you to fix the currency exchange rate, term, day of the transaction, etc. At the same time, you will not spend any extra funds, and there will be no need to withdraw the required amount from circulation.
The option will be more profitable to use when the firm is hedging a small payment, using foreign currency funds infrequently, or there is no guarantee that the payment will be required on a specific day.
Where can I buy financial instruments?
Once you have decided which instrument you will use to prevent risks in the event of a change in the exchange rate, you need to choose where you will purchase it, in a bank or on an exchange. The main difference is that on the exchange, all instruments relate to certain standards, are offered at a certain price and with certain redemption conditions.
In the bank, you can make transactions with forwards on any terms, that is, choose a convenient date for the execution of the contract and indicate the desired amount of foreign currency exchange. If there is no guarantee required, then you will not pay any additional fees to the bank.
Thus, if your firm already has an account on the exchange, you can choose derivatives there. If you need more loyal terms of the transaction, then go to the bank.
As a rule, the larger the volume of trade with foreign countries in a company, the higher the financial risks due to changes in the exchange rate. If your business depends as much as possible on fluctuations in the euro or dollar exchange rate, you should definitely think about protecting yourself from currency risks.
At the same time, the scale of the business and the status of the company does not matter. Whether the dollar exchange rate decreases or increases, any firm involved in foreign exchange transactions, regardless of whether it is a large holding company or an individual entrepreneur, is exposed to risks.
Do not waste time and think about how to reduce the dollar exchange rate, this is an inefficient and useless activity. It is better to carefully analyze the activities of your company and choose a suitable and effective strategy to protect against currency risks.