For the unwary, buying and selling in foreign currencies can be a minefield.
Cameron Cooper explores methods for hedging those foreign exchange risks so you can manage margins and cash flow.
As an exporter of indigenous flowers to the rest of the world, Jamie Creer knows how crucial foreign currency management is to the success of his business.
“It’s totally critical, if you want to sleep at night,” says Creer, managing director of the Australian Flower Company, one of the nation’s most successful flower distributors to nations as diverse as the United States, Japan, Taiwan and India.
Shipping perishables to far-flung destinations is a constant hazard, and the company takes a conservative approach to risk management. “We always hedge,” Creer says. “We don’t leave ourselves open. We don’t always get it right, but I don’t gamble. I take a position and then lock it in against the invoices that I’ve got coming in. That’s a discipline that you’ve got to have.”
Hedging, a strategy used to offset market risk, is one of the key tools of trade for sophisticated exporters as they try to manage the volatility of the Australian dollar, which has fluctuated over the past 30 months from 48 cents to 80 cents against the US greenback before settling recently at about 73 cents (at time of print).
To illustrate the importance of getting forex (foreign exchange) strategies right, consider this example: Fictitious Trading Co plans to import goods from New York, with payment of US$200,000 to be made in four months. At an exchange rate of 67 cents, for example, it would have to pay A$298,000. However, if the exchange rate fell to 60.3 cents, Fictitious would have to fork out A$330,000. Locking in a forward contract at 67 cents would guarantee the conditions of the transaction.
While hedging and other foreign exchange-related terminology are generally well understood in large corporations, they can bewilder smaller exporters. Estimates vary, but Austrade suggests that about a quarter of medium-sized businesses opt for hedging, but as few as one in 20 small businesses do this.
According to Martin Crawford, Travelex Australasia’s managing director, too many SMEs fail to protect themselves from currency fluctuations, which is placing them at “unnecessary financial risk”.
East and Partners’ SME Banking Markets Report last October, found almost 83 percent of SMEs with turnover between $5 million and $20 million use spot foreign exchange deals, with only around six percent using forward exchange contracts. “They have a lot to lose, as one bad currency fluctuation can wipe out their entire business,” Crawford says of the statistics.
“Small businesses need to develop foreign exchange strategies, not with the purpose of making money but rather protecting their business financially. And if they don’t use hedging as a business tool they cannot protect themselves from any adverse movements in the exchange rate.”
Ian Rogers, trade services manager for Australasia at HSBC, agrees, saying for many smaller operations foreign exchange risk is “something they totally overlook”. Although he has witnessed an increase in SMEs covering their exposure at all times, or taking an active approach to risk management strategies.
“The smaller the company, particularly if their margins are small, [means] any small movement in the rates can affect their bottom line,” he says. Fixing hedging policies from the start of a contract ensures a business can accurately forecast costs and profit margins on any export transaction. “Everything is then fixed in place so that any move [in foreign exchange rates] either up or down doesn’t affect that contract.”
The fact is, most Australian exporters have to deal in a foreign currency, and in most cases they are swapping greenbacks. Up to 90 percent of Australian import and export trade is in US dollars, according to Rogers, who says “unfortunately, while not being insignificant, the Australian dollar is not what you would call a major currency on the international markets”.
He maintains, however, that Australian companies can be competitive while trading in US dollars as long as they have a sound risk management strategy. And the alternative, trying to trade in Australian dollars, may not be acceptable to their counterparts overseas. “If a company insists on dealing in Australian dollars they may be putting themselves more at risk of losing contracts than if they were dealing in US dollars.”
When negotiating foreign currency deals with financial institutions, exporters are usually given a choice of spot rates and forward rates. The spot rate is the price at which the currency is presently trading and is a function of market conditions. Forward rates are determined by interest rates around the two currencies involved in the transaction.
Matt Gilmour, managing director of OzForex, one of the world’s largest online foreign exchange services, advises smaller businesses to take the complexity out of forex deals.
While many banks have a range of new “sexy strategies” and products, he believes simple forward contracts are appropriate for most SME exporters. Such contracts allow businesses to lock in an exchange rate without having to pay for the purchased currency until a future date.
“In some cases complexity is required, but normally that would be for big mining companies and the like that are looking to hedge out 10 years of receivable, but most [SMEs] would not be in that league,” Gilmour says.
OzForex argues that a more complex options strategy, which protects an exporter against appreciation of the Australian dollar up to a certain point, tends to have less transparent pricing. And there are so-called knockout options where the buyer selects a price at which the option lapses, and after which the buyer is left uncovered. In short, such trades are more sophisticated and more risky.
Gilmour agrees most Australian exporters are obliged to trade in US dollars. “But it’s really straightforward to manage that risk, and so there’s no reason why exporters should price in local currency.”
While some exporters opt not to hedge at all, Gilmour questions the merit of such a decision, saying the historic volatility of the Australian dollar can take all the margin out of their sales. He views hedging as just another basic form of business insurance.
Foreign Exchange Dealer
In determining which institution to choose as a foreign exchange dealer, it is worth noting that the Big Four banks and major international trading houses typically point to their experience and global networks, while the independent agencies argue they offer more competitive prices.
Gilmour says independents such as OzForex “live and die by their pricing”. He suggests SMEs shop around and, irrespective of the financial institution they choose, get a guarantee of a fixed margin on the inter-bank rate from their provider. “That way, it’s fully transparent and once they do that they can keep monitoring the exchange rates they’re getting and making sure they’re getting the margin they have negotiated.”
Paul Edwards, senior manager of risk management advisory at HSBC, argues that his bank’s scale—it has offices in about 80 countries—provides a real advantage for clients who can tap into international networks for market-specific advice without introducing external players. “The network and the capabilities of being in all those places can
’t be understated” he says.
His bank has also introduced a sophisticated e-Treasury online support platform, which adds to clients’ business flexibility. Many exporters are dealing into Asia and Europe at night after domestic bank branches have closed, and the online tools allow them to monitor and transact on market moves around the clock.
Dealing online is becoming more common for SMEs and other exporters. It is more efficient than old phone and fax orders and allows traders to quickly compare inter-bank rates. The Commonwealth Bank, for one, has moved to address poor customer satisfaction levels with the launch of a foreign exchange online service targeting SMEs. It will allow businesses to buy and sell foreign currency at the click of a mouse, while getting live forex rates on their computer screens.
Thanks to online trading, including Travelex’s Fxpaynet, Crawford agrees it’s never been easier to trade with the rest of the world. “Any business, irrespective of its size, can now protect itself financially with this simple and user-friendly online foreign exchange service.”
And with online security, the key is to secure account details with the appropriate software firewalls.
At the Australian Flower Company, Creer appreciates online tools and the ability to track currency movements on the web, but he still prefers to talk to a trader before closing a deal.
For a man who prides himself on developing great export relationships with clients wanting Australian natives and exotics such as waxflowers and kangaroo paws, his emphasis on relationships carries through to his forex needs.
He believes relationships, service, and robust information, are essential when selecting a financial institution. “At the end of the day, yes, you may get a better deal if you shop around every day but no one has time to do that,” he says. “So, if you have a good relationship and you know they are doing the right thing and their rates are competitive, I think it’s important to understand the people you are dealing with.”
Creer says he has won and lost on currency movements, and sometimes has had to cut the price of his goods and take a loss on margins. It is, he says, all part of cash flow management and knowing how to report foreign currency deals appropriately. He advises business owners to closely monitor foreign currency buying and selling performances, and to list them as a separate line item in accounting statements.
“If you just let it get lost in margins you could be attributing a good trading season to the fact that you are selling well, when in fact your profits are coming from your foreign exchange management,” he says.
The upshot for Creer is that he never wants to leave himself exposed to currency shifts because, “I know what effect it could have on me and my profits.”
Foreign Exchange Jargon
Hedging: a strategy designed to reduce or eliminate the risk of an investment. In exporting, a hedge is a popular financial instrument that manages the risks of an uncertain future exchange rate.
Spot foreign exchange: contracts allowing the immediate exchange of foreign currency cash flows into an alternative currency. The spot price of a currency is quoted for immediate settlement of a contract. Settlement is typically one or two business days from the trade date.
Forward exchange contract: contracts providing for the exchange of foreign currency cash flows into an alternative currency on a future settlement date. One party agrees to buy, and the other to sell, for a price that is agreed upon in advance.