Looking Overseas For Opportunities? You Should Be Aware Of Foreign Exchange Risks
If your business deals with foreign currency, you’ll know that foreign exchange risk could seriously affect business profits and revenue. The Australian dollar’s plunge against the Singapore dollar, for instance, has impacted profits for Singaporean firms with significant exposure down under.
However, do you really know what foreign exchange risk entails? Here are 5 things you need to know.
1. How does foreign exchange risk work?
Foreign exchange risk refers to the risk of changes to a business’s financial performance caused by fluctuations in currency exchange rates.
These scenarios are common sources of foreign exchange risk:
- Your business exports to overseas markets. Say your business exports products or services to the Malaysian market, and therefore derives revenue in Malaysian Ringgit. If the Ringgit depreciates against the Singapore dollar, the value of your revenue will decrease, while your costs remain the same.
- Your business imports from overseas markets. Now, what if you import products or services from overseas but earn revenue in the Singapore dollar? If the currency of that market appreciates against the Singapore dollar, your costs will go up, while your revenue remains the same.
- Your business has overseas assets or subsidiaries. When your assets or liabilities are denominated in a foreign currency, fluctuations in exchange rates will change the value of your assets and liabilities.
2. What happens when the domestic exchange rate falls or rises?
In order to understand the impact of foreign exchange risk on your business, a quick refresher of Macroeconomics 101 is helpful:
|A falling domestic exchange rate could…||A rising domestic exchange rate could…|
|increase costs for importers||make exports less competitive|
|increase competitiveness of domestically produced products against imported products||decrease the value of foreign currency income after it is converted to domestic currency|
|increase competitiveness of domestically produced products that are exported overseas||decrease the value of overseas investment|
|increase costs of overseas investment and capital expenditure||decrease costs of overseas investment and capital expenditure|
3. How do you measure the impact of foreign exchange risk?
CPA Australia outlines four ways businesses can measure foreign exchange risk:
- Register of foreign currency exposures. This is a simple method that just involves keeping a register of everything you do that involves foreign currency, and recording each item against its relevant exposure.
- Table of projected foreign currency cash flows. If your business both pays and receives foreign currency, measure each currency’s net surplus or deficit by projecting foreign currency cash flows.
- Sensitivity analysis. This is an extension of the previous method, whereby you measure the potential impact of movement in exchange rates. This involves measuring impact by choosing arbitrary movements in exchange rates and measuring their impact. For example, if the Singapore dollar drops by 5% against another currency, how would that affect your revenue? What if it drops by 10%? Running through these different scenarios can help you measure the impact of currency fluctuations on your business.
- Value at risk. This is a complex method that is typically used by large organisations, involving a probability approach when performing sensitivity analysis.
4. How do you manage foreign exchange risk?
There are a few ways you can minimise foreign exchange risk:
- Use forward contracts. A forward contract is an agreement to buy or sell at an agreed exchange rate at a set date in the future, regardless of what the exchange rate will be then. For example, if a client is importing your goods in Singapore dollar, the client has to honour a forward contract even if the Singapore dollar appreciates against their local currency.
- Use foreign currency options. A foreign currency option gives you the right (but not the obligation) to buy or sell currency at a certain price. In exchange for this right, you have to pay an up-front premium.
- Pass it on to your customers. A last-resort method would be to pass on any increase in prices due to currency exchange fluctuations to your customers. If changes in exchange rates cause your products or services to cost 20% more, for instance, you raise prices by 20% more. Of course, this method can be incredibly risky – you may lose customers to other products or services that more competitively priced.
5. Online remittance services can be useful
If your business involves receiving or making foreign currency payments, using an online remittance service over bank transfers can be helpful. These services that have cropped up in the last few years promise a more cost-effective, transparent fee system for transferring money overseas.
Some online remittance services, such as WorldFirst, also provide foreign exchange solutions that are tailored for businesses. These include rate alerts so that you’ll always be informed when exchange rates are favourable, or firm orders to help you automatically complete a transaction when rates get to where you want them to.
Don’t overlook the impact of foreign currency risk on your business
If your business has any sort of overseas exposure, the constantly fluctuating currency exchange rates can put your profits and revenue at risk.
Learning how to protect your profit margins by understanding currency exchange risks allows you to plan your business costs more accurately.
It’s worth putting a plan in place or figuring out what the best tools are to mitigate these risks to put you ahead of the game.