How to Minimize Risk in Foreign Exchange
In today’s global economy, more small business owners are managing international transactions. With this added responsibility comes the added complications of dealing with foreign transactions and fluctuating exchange rates.
Foreign exchange that is not well managed can lead to losses; however, with strategic planning, the risks of foreign exchange can be mitigated. The first step is to understand the risks, which include:
- Transaction exposure
- Economic exposure
- Contingent exposure
- Translation exposure
A company has transaction exposure when it has receivables and payables that are subject to changes in exchange rates because they are in a foreign currency.
A company has economic exposure if there are unexpected exchange rate fluctuations.
A company's translation exposure is based on how financial reporting is affected by exchange rate fluctuations. As a business prepares financial statements, any foreign assets and liabilities are translated from foreign to domestic currency, which exposes the business to foreign exchange risk.
A company has contingent exposure if it bids on foreign projects or investments.
Below you will learn how to reduce losses and risks using spot orders, market orders, and forward contracts.
Spot orders are an attractive option to meet your immediate currency or payment needs. A spot order simply refers to buying funds now, or “on the spot.”
Spot orders are basically the details of an agreement on a spot trade between two parties that is settled on an agreed upon date – the spot date. A spot trade is the purchase or sale of a foreign currency exchange, financial instrument, or commodity. Spot orders are convenient when you need to complete a financial transaction on the same day or within 48 hours.
Once you agree to the price, the currency is purchased on your behalf, and the funds are delivered to where you need them. It’s that easy, and you know the exact exchange point you are transacting at.
Like buying or selling stock at a predetermined rate, a market order allows you to name your desired price. Unlike the spot order, a market order does not have a specified time to sell. It allows you to nominate the length of time you would like the order to stand.
You select your rate, place the order and your Currency Specialist will contact you as soon as the market order fills to make arrangements to settle the transaction. If the market does not reach your chosen rate, you are under no obligation and may cancel at any time. Using a market order reduces FX risks, as you only execute a currency transaction when your target level is reached. This gives you control on exactly when to transact at a rate you are comfortable with.
A forward exchange contract is the agreement to exchange currencies at a specified time in the future. A forward contract allows you to protect your future contract and service commitments by locking in future payment and currency exchange needs at today’s rates. By locking in your rates, you remove the risk of future currency volatility in the market. That volatility could wipe out all the profit in your commitments. Fix your exchange rates today with a forward contract and remove that risk.
Spot orders, market orders, and forward contracts can work individually or together to build a bespoke foreign exchange strategy that meets your requirements. These products are an integral part of planning a currency strategy that will manage your budgeted rate and your timing requirements.