Currency Hedging For Importing Businesses.
Currency Hedging For Importing Businesses.
sale is in progress
One of the biggest risk factors involved in operating an importing or exporting business is that while your sale is in progress the value of a foreign currency may change relative to the value of the U.S. dollar. This means some of your export profits can get lost in translation.
Overseas buyers typically pay in their own currency, which is then exchanged for dollars before it’s deposited in your bank. Here’s an example: You thought you were going to get $500,000 for that shipment of wooden chairs your company exported to France. But by the time your goods make their way overseas on a barge and the buyer takes delivery, the dollar has weakened against the euro and you end up only getting $460,000.
On the flip side: Instead of weakening, the dollar strengthens suddenly against the currency your buyer uses. By the time your merchandise arrives, it costs the buyer more in the local currency to equal the dollar value you agreed upon, and now the buyer doesn’t want to take delivery and close the sale.
As you can see, currency fluctuations can really take a bite out of your profits. That’s why savvy exporters and importer’s use currency hedging to protect their companies from the risk of changing currency values. All the big retailers that operate internationally use currency hedging to make sure their profits aren’t eroded by currency changes, and small businesses can do it, too.
Many businesses of all sizes often Import items from foreign countries and as such are required to deal with many different currencies on a regular basis. However, when holding currencies it is important that they too hedge their currency exposure. Hedging may sound complicated but all it refers to is methods of trying to reduce your exposure to the various risks outlined in the other articles in this section. As the currency market is as volatile and unpredictable as ever, many companies and individuals are looking to hedge their currency portfolio, corporation or foreign assets from the risk of fluctuations.
The type of currency hedging strategy used, will depend on the expectations and needs of the importer. A greater desire for flexibility may propel the importer to opt for swaps and options. In case of forwards and futures, familiarity with the counter party to the contract would determine the strategy.
Major banks offer currency forward contracts, which are essentially an agreement to exchange certain amounts of dollars for foreign currency on a future date. This allows you to lock in an import purchase or export sale at the current exchange rate, guaranteeing your transaction at the agreed upon price.
Of course, if the U.S. dollar strengthens afterward, you can’t profit from it; you’re locked into an exchange rate. But you have protected your business from the risk of a weakening dollar.
If you’re an importer and need to purchase merchandise abroad, one currency-protection method is to simply open an account in the country you are importing from. When the exchange rate is favorable, send U.S. dollars to your foreign account for deposit. The bank will change them into the local currency.
Now the money is locked into the other country’s currency and ready to spend. The downside here is it’s hard to time currency fluctuations.
One option for an importer is to enter into a forward contract to buy a fixed amount of a currency for a given amount of GBP, USD etc. A currency forward contract is an agreement to purchase or sell the currency at a pre-agreed price at a set date in future, regardless of the price of the asset in the spot market.
Assets are traded at the currently prevailing prices in the spot market. The two parties to a forward contract are the long and the short. This arrangement helps eliminate uncertainty, in the amount of payment that has to be made for imports, on account of fluctuating foreign currency.
The importer can take a long position in the forward contract and thus
Similar to these contracts, a futures contract was designed in order to overcome the disadvantages of a forward contract. One of the disadvantages, of a forward contract, is that the
contract is not standardised. Essentially, the entire payment has to be made or received, in one go, at some point of time in future so the
chances of default are high. Thus a futures contract that allows the importer to pay a set price for the Euros that would be purchased at
a later date, can help him hedge foreign exchange risks.
The final option for businesses looking to import is currency swaps. The importer can enter into a currency swap with a European trader who needs Dollars. In other words, the importer exchanges a fixed amount of Dollars for Euros so that he has the necessary foreign currency to make payments in future. The importer is expected to pay interest, at a fixed or floating rate, on the Euros borrowed while the European trader pays interest on the Dollars to the importer.
On the maturity date of the swap, the currencies are exchanged so that the parties have the currency they started out with. These swaps are
negotiable for at least 10 years, thus making them a highly flexible strategy for currency hedging by importers.
Banks offer currency options, which give you an opportunity, but not an obligation, to buy or sell a set amount of currency at a set price, on or before a chosen date. Options come with a “strike price,” the price at which the currency can be bought or sold, and an expiration date, after which your opportunity to purchase at the agreed upon price ends.
In essence, futures and options allow you to bet on where currency prices will go. You lock in at a rate you’re hoping will be at least as good as the actual rate when the contract or option comes up.
An important drawback to note about contracts and options is that each of these currency-hedging strategies comes with fees and commissions charged by the bank, exchange, or other party administering the hedging vehicle. Weigh those costs to your business in evaluating whether you want to hedge currency.