Currency exchange management can often be seen as a headache rather than a fundamental business process. This is a by-product of conducting international business or working within the import/export sectors which is littered with head-scratching variables – so some clarity is crucial. Before focusing on the factors that businesses must consider when implementing a currency management policy, it is important to understand how currency risk impacts decision making and profitability.
A quick glance at historic GBPUSD pair reveals the challenges businesses face when managing currency risk:
• GBPUSD forecasts from over 40 financial institutions range between 1.4700 to 1.2800
• Since 2000, the average difference between the high and low in GBPUSD has been circa 14% per year
Predicting the direction of currency markets expose businesses to a large margin of error, based on the historic high-low range and the large disparity between the financial institutions forecasts – potentially impacting the monetary values associated with good and services.
To put this into perspective, a business conducting international trade that’s operating on a 10% profit margin for its goods and services could see its profit margin impacted by 10% from a 1% move in the currency pair required.
Budget vs Costed Levels
A business’s approach to managing its currency requirements may be determined by the ability to pass on additional costs or savings to the end-users – and the net impact on retention and profitability.
Typically, budget rates are used in a company’s financial forecasting, while a costed rate is the real rate of exchange that considers the costs associated with products, production, and projects. Some businesses will maintain a cost level that’s the same as their budget level due to costs being fixed. However, others need to consider variable changes such as the impact currency movements have on supply chain logistics, raw material, and production costs – changes that will affect a business’s profitably.
Certainty of exposure
A business may be able to forecast its currency requirements based on historic data. For example, a clothing store could forecast its requirements with a large degree of certainty based on historic sales. However, a tech company that’s launching a new product may not benefit from such foresight due to the lack of data on historic sales.
Seasonal adjustments also need to be taken into consideration. For example, a toy importer is likely to require a larger amount of currency when stocking for Christmas.
Businesses should consider the time frames involved with their currency requirements – for example, when invoices need to be paid. This enables a business to reduce the risk of currency pairs moving significantly by deploying strategies or using specific products.
Budgeted or costed levels, uncertainty of exposure and time frames can influence the end user pricing, particularly if a business is trying to maintain real profit margins. This may come down to the sensitivity of price changes and the stickiness of demand.
A good example of fluctuating prices generally being accepted is the price of petrol, which is largely due to necessity. On the other hand, a sharp price increase on a plain white t-shirt may not be absorbed by the consumer and demand may decline as a result.
Another consideration is how the competition is pricing their products, based on their production cost and how that could impact market share.
Managing your currency risk exposure
Currency risk management is not a ‘one size fits all’ process. To effectively manage your currency risk exposure, your business must understand its overseas payment goals and risk appetite. Only then can you focus on choosing the right products to underpin your strategy.
There are a range of products and strategies that can be used to manage your currency exposure. This includes products that provide you with price stability by securing the exchange rate at the time of execution. Others work based on a buy now and pay now model.
What is appropriate for your business may depend on what sector you work in, your profit margin, your ability to adjust your price to the end-user or even how your competitors are transacting their currency.
Look out for our next blog, where we will highlight various strategies and products that could be useful for your business.
This blog post is intended to provide you with information on the services Lumon Pay Ltd (“LPL”) offer and should not be interpreted as advice or as a solicitation to offer to buy or sell any currency or as a recommendation to trade. Foreign exchange rates provided therein are for indicative purposes only and are not intended to give an accurate reflection of current currency exchange rates or to predict future movements in currency exchange rates. LPL, trading as Lumon, is a company registered in England with its registered address at Building 1, Chalfont Park, Gerrards Cross, Buckinghamshire SL9 0BG. LPL is authorised by the Financial Conduct Authority as an Electronic Money Institution (FRN: 902022).