As you should know, each country or economic zone has its own currency.
To begin with, you need to understand one important point: there is always a currency risk when you work with a partner that does not have the same currency as you.
The question is, who bears the risk? The importer or the exporter? There is no right answer to this question, but if the currency exchange is well mastered it can become a real commercial and financial asset.
Foreign exchange risk is the uncertainty of the conversion rate of one currency to another. This is an important point for companies because fluctuations can affect invoice amounts and therefore the commercial margin.It is important to understand that an exchange rate at one moment will not be the same 30 days later, when the invoice is paid.
The rate changes every second, so no one can predict the impact it will have on costs and margins. Whether you are exporting or importing, it will have an impact because your partners will also take into account the exchange rate when working with you.
The French company Dupont sources most of its products from China. Today, they have just received an invoice to be paid in 30 days for an amount of 100 000 USD. The EURUSD exchange rate is currently 1.10, i.e. EUR 90,909. Mr. Smith decides to wait before buying dollars.
The settlement date has arrived and Mr. Smith must now buy dollars.
- Scenario 1: the price is now 1.07. Mr Smith buys 100,000 USD for 93,457.94 EUR. This means a margin loss of EUR 2,548.94.
- Scenario 2: the price is now 1.13. Mr. Smith buys 100,000 USD against 88,495.57 EUR. This means a margin gain of EUR 2,413.43.
Both scenarios are spot transactions. That is, you buy the currency you want at the current market price.
The important thing to note here is that the loss or gain is a risk for the company making the trade. No one could have predicted the rate 30 days before. What you have to consider is that the final prices are not necessarily changeable with the final customers. So if scenario 1 happens you can lose all the margin because of the volatility of the exchange rates. That’s what we call currency risk.
Ways to protect yourself from price volatility:
However, there are ways to protect oneself from volatility and therefore to secure the margin and costs: forward contracts.
Forward contracts are financial products that allow you to lock in the exchange rate on a specific date or between two dates without committing cash or committing a limited portion of the desired amount. There are different types of forward contracts with varying degrees of participation, but all have the same purpose: to protect you from volatility. The names of these contracts may vary depending on the financial institution you work with.
To understand how futures contracts work, let’s go back to our example with Mr. Smith.
The company Dupont receives an invoice for 100 000 USD to be paid in 30 days. However, this time Mr. Smith does not want to risk his margin and decides to protect himself.
The current rate of the EURUSD is 1.10. Mr. Smith calls his financial institution and decides to take out a forward contract to buy 100,000 USD in 30 days at today’s rate.
- Single scenario: 30 days later, Mr. Smith buys 100,000 USD at 1.10, i.e. EUR 90,909.
The current rate is not important when converting because Mr. Smith has protected himself against the exchange rate risk. If the rate was 1.07 as in scenario 1, he would have made a very good operation. In the case of scenario 2, he will have lost an opportunity. But in any case Mr. Smith will have secured his margin.
There are several types of forward contracts. Some also allow you to participate in the market to take advantage of an opportunity in your favour. However, it is important to understand that these products allow you to secure your margin and not to impact your costs unfavorably. Foreign exchange risk is a risk that can be controlled if you are well accompanied.
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