One of the most overlooked subjects in business is foreign exchange. With more and more small businesses opening themselves up to overseas markets – or even overseas suppliers and remote workers – exchange rates have a deep impact on businesses.
Even the smallest of foreign exchange rate fluctuations can have a large impact on the financials. It’s very common for even the most common of currency pairs to fluctuate by 1% in a day, and just earlier in April 2022, the EUR/USD pairing fluctuated by 2.34% in only one week. If a European business theoretically had all of its income from the US, its revenue that week could be down by a few percent for no reason other than price fluctuations. Of course, some currency swings are much more severe than this, too.
Achieving the optimal exchange rate is therefore a very overlooked but important topic. Being subject to such currency fluctuations can mean being a passenger to swings in your cash flow. Let’s not forget that if you’re using overseas workers and supplies, costs could be experiencing similar levels of unexpected rises. This makes it incredibly difficult to accurately forecast your cash flow.
It’s not about being able to time or predict the market, as achieving the optimal exchange rate can imply keeping a steady, reliable exchange rate. The less volatility, the less risk, and the more certainty you have over your future business.
How foreign exchange rates work
FX rates seem like a centralized thing where the price is set. In reality, it’s the result of the free market allowing supply and demand to do their thing.
Currently, 1 USD can buy 0.80 GBP. In a superficial sense, the GBP is, therefore, more valuable. Although it’s an abstract concept, this price is essentially the equilibrium between supply (the amount of a given currency that is up for sale) and demand (the amount of demand there is to purchase a currency). To change either supply or demand will change the exchange rate. Because fiat currencies don’t have inherent worth, it’s all relative.
So, let’s say that the UK releases news about its economy doing very well recently. This could give confidence to investors that the UK will provide good investment returns, so foreigners purchase GBP to make British investments. This makes the GBP more popular (GBP demand increases), and if some of these foreigners are American, then the USD goes on sale in exchange for GBP (USD supply increases). Both factors cause the GBP to appreciate and grow stronger, thus changing to something like a USD/GBP of 0.7. So, now it takes less GBP to buy 1 USD. This is good for a British importer but bad for a British exporter.
Now imagine an infinite amount of factors, from confidence and speculation to economic news and technical analysis indicators – totally unpredictable price changes. FX rates are constantly changing because they’re open 24/7, unlike most other markets.
How to hedge against these fluctuations
Before moving on, it’s important to concede the possibility of “winning” when it comes to fluctuations. You may get stung more than you benefit or vice versa, but you can never be sure, you can never predict, and this in itself is a net loss. Letting ourselves be exposed to price fluctuations is to retain less control over your business and is essentially a form of inactive, passive gambling.
The way we protect ourselves from currency risk is to use hedging tools. These tools help us lock in an exchange rate that we can access later on in the future. For example, a forward contract means we agree to purchase $5,000 for £4,000 in 3 months’ time. On this exact date, the transaction must go ahead. You pay a small fee for this luxury (and this fee helps keep the hedging provider profitable given the potential fluctuations). If you’re not certain that you can/will make this $5,000 exchange, an option contract means you have the option to on that date, which usually incurs a slightly larger fee.
This sounds complicated and administrative, but it’s become increasingly accessible and convenient. There are many business foreign exchange providers that essentially offer these tools to small firms (or even individuals), and talk you through it over the phone. It’s best to go to an FX specialist that specializes in business though because they will help protect you from making any hedging mistakes (i.e. locking in a forward contract when your income isn’t guaranteed).
The world today is fully globalized, so most businesses have to deal with international payments all the time. Whilst currency is often overlooked, FX business specialists are completely in touch with these typical, common concerns around currency risk, making them highly experienced with small firms. It’s difficult to even run a t-shirt business without involving international payments. And, if you’re relying on a host to handle such exchanges (i.e. Shopify, PayPal), then not only are you not in control of when and how you exchange (you can’t wait and hedge), but you’re likely being extorted with a 3%+ exchange rate fee/spread.
How to know if your foreign exchange management is optimal?
There is sometimes an option of only transacting in your own currency. This means asking international customers to pay in your currency, leaving the exchange up to them. However, if the customers are not using appropriate services, they may be getting extorted too with terrible exchange rates, as well as being exposed themselves to fluctuations. In both instances, the price of your goods becomes much more expensive, which can impact demand.
It’s best to have receiving accounts in your customer’s country. This is achievable with multi-currency wallets at FX specialists that produce bank details in many overseas countries. This gives you full control over when, where, and how to exchange all of your income – this would produce an optimal foreign exchange balance. Relying on a domestic bank account is a recipe for disaster, with poor business foreign exchange rates and less control.
It’s vitally important to create payment forecasts specifically for FX, not just total payments. This allows you to grasp the scale of your currency exposure, and also how much would need to be hedged. The same goes for forecasting costs – specifically, overseas costs should have their own examination. Any hedging that is created should only be with certain FX money, not forecasted money that may not exist on the transaction date. Some hedging is better than none, after all.