Imagine you are a growing enterprise, acquiring clients in different parts of the world. You may also be relying on suppliers, some short-term and some long-term. How should you pay them? What currency should you use? What is the cost impact of agreeing to a contract paid in one currency and then paying out in another?
Now factor in market fluctuations, foreign currency volatility and external impacts such as the current pandemic, labour market slowdowns, and changes in political leadership globally. It’s clear that owners of small and medium enterprises (SMEs) can face major challenges to their cash flow management. As well, volatility in the currency market could affect the value of the company’s assets and liabilities, thus limiting your ability to borrow or extend a line of credit.
One of the best strategies for ensuring success when expanding your company internationally is to consult with experts. Alexander Youngman, Currency Strategist with GPS Capital Markets, one of B2BeeMatch’s trusted sponsors, has shared his insights about foreign currency markets and the mistakes SMEs can make with foreign currency exchange on the B2Bee Blog. Here, he explains the various risks an SME could face and how working with a forex broker can help SMEs navigate the foreign currency exchange market successfully.
To start with, SMEs have a number of tools to help them manage the foreign currency market. They can use spot transactions, currency forwards and options to buy foreign currency. Each method offers various types of flexibility to protect the business and each comes with different risks. The key is knowing how to choose the best possible option while reducing risk and maintaining profitability.
When you buy foreign currency without delay on a specified date, it’s called a spot trade or spot transaction.
“Spot is simply the idea of buying or selling foreign currency when you need to. You have the flexibility to buy and sell as much as you wish. However, you are exposed to the existing market level,” Youngman says.
While risk increases with the number of different currencies you work in, risk also increases with the size of a single transaction too, says Youngman.
“Let’s assume the client agrees to an order today at an exchange rate of 1.17. In six months’ time, the client has to pay $117,000. With spot transactions, when the delivery date comes, the client could buy the $100K USD at the current market rate. This could be in their favor: if the exchange is 1.19, they could make an added profit. Or it could go against them if the rate is 1.15, resulting in a loss.”
In that context, while you could have an extra gain or an extra loss, the risk is you don’t know which it will be. This is where a future-based purchase contract, also called a forward contract, can help. With a forward contract, you buy or sell a pre-agreed amount of foreign currency for a pre-agreed date at a pre-agreed price.
In the example Youngman outlined, a company would buy $100K USD at the market price of 1.17 for a fixed, six-month term. When delivery day comes, the client would use their forward contract and buy $100K USD at 1.17.
Says Youngman: “This means that no matter where the existing market is at, the client will get $100K USD at 1.17. There are pros and cons. If the market is in the client’s favor, they must still buy at 1.17 and therefore under market. However, if the market is at 1.15, then the client is buying at a better price and therefore reaps the benefits.”
An added advantage to a currency forward contract is that it doesn't require an upfront margin payment and you can customize the contract to your needs.
The most important thing to remember here is that if the client built in a profit margin of 10%, then at the end of the six-month period, the company owner knows they will achieve their profit margin. There is no risk of losing the profit margin.
Youngman says options are products that allow you to build in protection levels while offering the possibility you will benefit if the market moves in your favor. Companies can build in more flexibility with options tailored to their needs.
With these options, the client in our example could protect their business by buying or locking in at 1.17. In six months, if the market has moved positively, they could buy the $100K USD at 1.19 and benefit from the move. On the other hand, if the market goes against the company after six months, with a rate of 1.15 on the delivery due date, then the client would still be able to purchase at 1.17 and still achieve the profit margin.
So how should a small business choose the right type of foreign currency transaction?
“Your options depend on the markets in which you operate and the level of risk you can bear. It’s a matter of finding the best structure which works for your company,” says Youngman.
If you know you will have a quick turnaround—usually within two business days—then a spot transaction will be your best choice. You may not get the best rate, but you will have reduced your risk for volatility in the foreign currency markets.
For SMEs with a larger client base in a single country, relying on spot transactions and a bank account in that currency may be your best bet. If you have more time to manage this transaction, then a forward exchange contract will give you a measure of protection. You won’t get the benefit of a better rate, but you also don’t risk having to pay more because the markets for your currency have changed. And if you’re not sure what your best option is, consider working with a broker.
How to choose a broker
When it comes to growing your company globally, working with a forex broker can help you become more agile in managing foreign currency exchanges efficiently and profitably.
Your forex broker can guide you on the best rates for purchases and offer support when making international payments as well as helping you manage the risks involved with foreign currency exchanges.
Assess your potential broker by evaluating these key factors:
-regulatory compliance: ask about reputation, references, and company track record
-contract features: ask how they manage deposits, withdrawals and types of accounts
-currency pairs: ask about what options will benefit you
-customer support: ask about 24/7 availability and access to live service people
-trading platform: ask about their customer interface, meaning ease and speed of use for managing transactions
Working with foreign markets, suppliers and contractors may seem daunting, especially when it comes to managing the volatility of foreign currency markets. However, educating yourself and consulting with a trusted broker will help you succeed in achieving your vision for global business growth.