If your business is trading internationally, it's likely that you'll have some provision for your foreign exchange, either to convert currencies back in to your home currency, or exchange funds to pay foreign suppliers, or both. Exchange rates are prone to ongoing fluctuations, which can greatly impact your commercial margins. And whether you’re buying or selling currencies, it’s difficult to accurately predict your finances.

A foreign exchange strategy can help to even out the impact of exchange rate fluctuations and protect your business from risk. 

Why are forex strategies important?

It's often challenging to see the full impact of foreign exchange on your business unless you're looking retrospectively. Even with the most detailed forecasts, it's difficult to predict what impact currency fluctuations will have on your business, given the sheer number of variables affecting market movements. 

But the currency market is capable of significant movements in a relatively short space of time.

If we look at the dollar as an example. Following 2022, when the US dollar reigned supreme, we started to see the dollar sell-off at the end of the year. And while we were always likely to see some reversal in 2023, the scale at which it has happened has caught many off-guard, with the pound and the euro gaining 15% against the dollar since October 2022. 

What does that mean for you?

It means that if your company is in the UK or the EU and doing any business with the United States, you could earn 15% less on those trades than in October last year. This is a very real example of how currency fluctuations can affect profits and can see you lose money before you've even done anything.

At this point, you might be sitting back thinking that actually your business has fared well over the period, but you need to also consider what might have happened if it was the price movements were the other way round – like in September 2022 when the pound plunged to a 40-year low of 1.0327 against the dollar after Liz Truss's mini-budget.

If the last year has taught us anything, it's that currency volatility can present a substantial risk to any business and it’s something every company should consider before they enter the international market.

What do you need to consider?

Buying overseas

Some overseas companies quote and invoice in pounds, but these suppliers can add further margin to the cost to limit their own risk, driving up prices. If they invoice in their local currency, the actual cost in sterling may be more or less than forecast because of the time between quotation and payment of invoices, which could see a change in the value of the pound. A stronger sterling could be good news, but a sudden drop in the pound can harm costs.

Exporting

While global expansion can increase revenue, fluctuations in currency values may impact the profitability of improved sales volumes. Quoting prices in the destination country's local currency helps build relationships with overseas markets, but it means your company bears the risk of changing currency values.

Multi-currency operations

Dealing in multiple currencies can come with financial risk due to the number of variables at play and the potential for added complexity. Resource costs for administering multi-currency operations can pressure margins already squeezed by currency fluctuations.

Where to start?

When building a trading strategy from scratch, we always advocate starting with our free audit of your foreign exchange history.

We provide technical analysis from up to 12 months of data, including the times and dates of your transactions, the exchange rates, the type of products your business uses, and what currencies you trade, to help paint a clear picture of your foreign exchange requirements and give you an understanding of your risk exposure.

We can then build a bespoke foreign exchange strategy. We look at two main inputs to build a strategy using our currency risk management tools. We’ll look at:

• What are your hedging objectives?
• What are the market conditions?

What are your hedging objectives?

The overall objective for currency hedging is risk management. It works almost like an insurance policy – you might not need it, but you'll be very glad it's there if you do.

However, we'll take a much more granular approach to suit your business needs when building an FX strategy. Many variables will dictate your risk appetite, but we always ask the same essential questions:

How much do you need and for how long?

Firstly, we'll look at how much business you are doing internationally. Is it a one-off order from an international client now and again? Or are you regularly ordering from several overseas suppliers? This helps us understand how much currency trading you'll likely do and over what timeframe.

What budget or cost rate do you need to achieve?

Businesses working to tight budgets or with cost rates that make up a large percentage of turnover might be more impacted by the effects of currency fluctuation. If your profit margins are small, even an incremental change in the rate against you could wipe it away.

We'll look at the potential impact of market movements against your budget objectives to help you understand what it means for your bottom line and how to mitigate the risk.

Are there internal considerations?

Your overall business objectives will also impact your FX strategy. For example, if you aim to grow your international business, your foreign exchange requirements will differ from those businesses focussing on their local market. 

How your business is structured will also affect this. Whether your business is made up of entities in different geographies, you have overseas payroll requirements, or it is based out of one place with supply interests in foreign nations – these are all factors that impact your foreign exchange provision.

What are the market conditions?

Exchange rates constantly fluctuate depending on supply and demand. Demand for currency depends on its perceived value based on market conditions. Historically, economic data and market sentiment have been critical drivers of foreign exchange market moves. From a data perspective, the performance of inflation levels, interest rates, retail sales, housing markets, and unemployment data all dictate how an economy performs.

We also consider market sentiment - how do investors, rating agencies, and other financial institutions view the performance of that economy? And, importantly, your views on the market.

What has a more significant and long-term impact at present are political events, as different political parties have alternative policies aimed at driving growth, reducing debt and keeping the public happy. The main thing to consider here is that markets do not like uncertainty, so events that have an unknown outcome, such as a close election or referendum, could negatively impact that country's currency.

It’s imperative to recognise that the relationship between these factors and the currency market is complex. Inflation, interest rates and foreign exchange, for example, are intrinsically linked, but while high inflation will likely mean high-interest rates - which could attract foreign investment and see a stronger currency - high-interest rates at the same time curb spending, which can reduce GDP growth, resulting in a weaker currency.

While it's impossible to predict every global event, it is possible to apply an understanding of market trends to help you leverage risk management tools and our expertise to protect yourself from this volatility and prepare for the future.

How will market movements affect your business

The key to understanding how market movements could affect your business is understanding the cost of volatility.

The currency market is the most volatile market and sees exchange rates between currency pairs fluctuate continuously. They can move up and down a few percentage points every day, which can equate to a significant difference when you're dealing with large amounts of money.

The difference between high and low exchange rates can be stark when you look at fluctuations across a whole year – or more. We spoke about the dollar dropping 15% against the pound and the euro earlier, but here you can see high and low exchange rates for 2022.

The difference between the pound and the euro was 13% last year, whereas the pound and the dollar was nearly 34%. These numbers can wipe out any business's profit margins, and if you're trading in these currencies, you need to understand what it would do to yours.

How are you protecting yourself against market volatility?

Some clients come to us with some risk management tools already in place. However, we often see issues with under or over-hedging.

Predicting currency exposure is difficult because so many variables are involved. However, it also requires precise forecasting of your incoming and outgoing foreign currency cash flow. For example, let’s imagine you forecast sales of $1 million in 2023, and you buy a forward contract for that year. If you only sell $800,000, you'll still be liable for the whole transaction. This is over-hedging.

What foreign exchange tools and products are right for you?

Once we’ve built a profile of your business, we’ll start looking at what tools we can leverage to help you.

Spot contract

This is the most straightforward contract for foreign currency trading. The price is quoted and booked for immediate delivery. This method is often used to make a one-off smaller payment or when you have a limited timeframe to make the payment. Spot contracts are the most common and traditional form of currency exchange, and typically the trade will be settled within two days, so it can protect you against short-term market fluctuations. 

Forward contract*

Forward contracts are an agreement to buy an amount of currency on or before an agreed date; they allow you to secure an exchange rate for future transactions. They can help protect you from unfavourable market movements and allow you greater control and visibility of your budget and cash flow without worrying about FX volatility.

Market order

These allow you to set up a target rate at which you are willing to complete a transaction. It is a great tool when you are optimistic that the exchange rate might improve. They can be used in conjunction with 'Stop loss orders', which help protect your transaction from going below a specific rate if the market moves against you. 

FX options**

Foreign exchange options sit somewhere between forward contracts and spot contracts. These tools give you the right, but not the obligation, to buy or sell a currency pair at a specified exchange rate within a specific time frame. FX options are highly customisable and allow you to hedge your currency risk while still being able to take advantage of favourable currency movements.

Moneycorp's approach to building an effective long-term strategy

Markets are generally cyclical, so we don't advocate a single trading strategy. At Moneycorp, our strategies tend to favour a more long-term, layered hedging approach.

A layered hedging strategy can help reduce the hedge rate's volatility. Through this approach, the overall rate achieved will be the average over all the periods covered and could smooth any significant peaks and troughs within the underlying rate.

This can be used to help you protect or lock in a targeted rate without over-hedging and allow flexibility to enter the market if it suits your future requirements.

Using a layered approach can protect part of your future exposure, giving you peace of mind and allowing you to manage the remainder of your requirements proactively.

Whatever your foreign exchange requirements are, we’re here to help. Why not use our free FX health audit to see how much money you could be saving on your foreign exchange?

* Forward Contracts may or may not require a deposit dependent upon your facility agreement.

**FX options are regulated products only suitable for businesses with specific requirements

All graphs and figures sourced from Bloomberg

None of the information contained in this article constitutes, nor should be construed as, financial advice.