How exporters can protect their margins from volatile exchange rates
The Australian dollar has been volatile in recent years, particularly since the onset of the COVID-19 pandemic. It’s important for exporting and importing businesses to consider how they can protect their margins against foreign exchange risk.
How does foreign exchange risk affect me?
Foreign exchange risk affects businesses that deal with more than one currency. Businesses that rely on imported or exported products may also be indirectly exposed to foreign exchange risk. Fluctuations of the Australian dollar relative to other currencies can potentially erode profit margins of exporters and importers. For instance, the rise of the Australian dollar (AUD) can negatively impact exporters – increasing their input costs and decreasing the competitiveness of exported goods relative to domestically produced goods. Meanwhile the fall of the AUD has the same affect for importers – increasing their input costs and decreasing the competitiveness of domestically produced goods relative to exported goods.
An appropriate risk management strategy can enable businesses to hedge against significant financial loss incurred by the fluctuations of exchange rate. It can also help secure core business operations and cash flow during times of uncertainty.
Methods of managing foreign exchange risk
There are various financial products for managing foreign exchange risk. What is best for your business depends on your individual goals and financial needs. Below are some strategies your exporting/importing business can adopt to manage foreign exchange risk.
Forward exchange contract:
This method enables businesses to hedge itself against adverse movements in exchange rates by locking in an agreed exchange rate until an agreed date. For instance, if your Australian business is expecting payment from a customer in US dollars in 30 days’ time, a forward exchange contract allows you to lock in a USD-AUD exchange rate now so you have certainty on the AUD receivable amount, regardless of what the exchange rate will be in 30 days’ time. The advantage of this method is that it provides cash flow certainty however business should note that the locked in contract price will apply regardless if exchange rates go up or down. This means that businesses may miss out on exchange rate movements that are favourable to itself.
Foreign currency options
This is purchasing the right but not obligation to buy or sell currency at an agreed upon rate. For example if a local importer enters into a foreign currency option with the bank for the purchase of goods denominated in US dollars for delivery in 2 months’ time, the importer will have the option to exercise the option if the local currency decreases in value to purchase the goods, or abandon the option if the local currency increases in value. The premium (which can be relatively expensive) is the price that the importer pays for the option. Options are beneficial as it guarantees importers protection from currency fluctuations.
Foreign currency bank accounts / loan facilities
This method of managing foreign exchange risk involves depositing surplus foreign currency in a bank account for later use, or by borrowing foreign currency to pay for foreign currency purchases instead of having to convert from local currency.
When determining which strategy is best for your business, its important to ask yourself – To what extent will currency fluctuations impact your business operations? How much loss are you willing to absorb as a result of the fluctuation of the AUD?
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