Unit 8 Banking : How to hedge against currency risk

Look at the language of advice and the vocab to talk about currency risk and we will discuss the situation in class:

If you’ve got a business with interests overseas — you’re importing or exporting regularly, or have an office abroad meaning you have to pay staff in the local currency — it’s essential to hedge against currency fluctuations. Failure to do so, says Christina Weisz, can really hit your profit margins, or worse.

The potential impact of currency markets on businesses should not be taken lightly. To give you an idea of how volatile currency markets can be, more money is traded in them daily than in the stockmarkets in a whole year: in excess of $1.5 trillion.
The vast majority of the money traded is the result of speculators and investors buying and selling currency in order to make a profit. Because of these speculators, exchange rates can move as much as 5 per cent in a week or 10 per cent over a month.

If you haven’t accounted for this volatility, and in our experience the majority of businesses, especially smaller ones, have not, an adverse movement in the exchange rate can severely impact your costs or profit margins.
It is absolutely vital, therefore, that you take measures to both hedge against your profits being wiped out by an exchange rate swing and to ensure you get the best possible exchange rate. But how do you do this?
Spot trade
Firstly, there is the "spot trade". This is when you buy the currency from the "live market" at a specific moment in time and pay for it at that time. The longer you give yourself to arrange your currency transfer, the more likely you will get the best deal as you can wait for the best time to buy.
High street banks will generally set a rate for a day, so you will usually be better placed to go to a specialist broker for this type of service, as they will get you the best rate at the moment you complete the trade.
Forward contract
Secondly, you can take advantage of a "forward contract". This is when you buy the currency now with a 10 per cent deposit and thereby lock into a rate but pay the remainder when you need the money.
Once you have fixed a rate you are protected from currency risk, meaning you won’t have any nasty surprises when you eventually make the payment. A forward contract can be fixed for up to 24 months and can be flexible should your timescales change.
Forward contracts are a highly effective way to hedge against currency risk and can provide directors with important peace of mind that they will not be exposed should currency markets move against them at the time of transaction.
You also need to ensure you are securing the best possible exchange rate and paying the least commission when exchanging currency. Understandably, perhaps, as they seek reassurance, most businesses automatically head for one of the high street banks — but you will always pay for the privilege.
To convert £200,000 into euros, for example, a high street bank will typically charge up to 4 per cent, whereas specialist foreign exchange companies will charge less than 0.5 per cent for the same service. Depending on the size of the transaction, this can amount to thousands, or tens of thousands of pounds, which can make a real difference to your bottom line.
Christina Weisz is a director at Currency Solutions, a currency exchange and money transfer specialist.
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