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Managing Exchange Rate Risk: A Detailed Guide

June 12, 2024June 15th, 2024No Comments

In international payments, small and medium-sized enterprises (SMEs) in the UK and US often grapple with the challenges of currency fluctuations. Headlines like “Imports Hit by Weaker Pound” or “Exporters’ Profit Margins Squeezed by Stronger Dollar” are commonplace, underscoring the significant influence exchange rates have on business operations. Recently, Unilever’s trading statement highlighted a 4% negative impact due to the Euro’s strength against the US Dollar and other emerging market currencies, partially offset by price growth in hyperinflationary markets. This scenario affects not only Unilever but also all companies engaged in international trade, showing that even major corporations face the challenges posed by currency movements.

So, how can SMEs navigate this volatile landscape as effectively as mega-cap corporations? At Rutland FX, we have been helping SMEs optimise their currency strategies for almost a decade. We are renowned for providing tailored currency solutions to businesses, assisting numerous SMEs and high-net-worth individuals in managing currency risk, maximising margins, and making informed decisions in the foreign exchange market. Leveraging our insights, this guide will walk you through essential strategies for effective currency costing and risk management, helping your business thrive even amidst exchange rate volatility.

What is Currency Costing and Why it’s Important?

For companies engaged in international trade, managing currency risk is crucial to maintaining profitability. Currency costing involves budgeting for exchange rates and incorporating these rates into pricing strategies to protect profit margins. Here’s a closer look at what this entails:

Budgeting for Exchange Rates

Businesses operating internationally need to forecast exchange rates and set a budgeted rate for the year. This rate is used to price products and services, ensuring that profit margins remain intact despite currency fluctuations. As the year progresses, companies may need to adjust this rate and reprice products to accommodate changes in the exchange rate.

Example: Currency Costing in Action

Consider a UK-based corporation that needs to purchase $10 million USD annually for raw materials sourced from the United States. Suppose they budgeted an exchange rate of 1.27 GBP/USD, meaning they priced their products to generate a 10% profit margin, assuming an annual cost of £7.87 million to buy $10 million USD. If the exchange rate moves 2% lower than their costed rate, dropping from 1.27 to 1.2446 GBP/USD, the cost in GBP to purchase the same $10 million would increase. Let’s calculate the impact:

  • Original costed exchange rate: 1.27 GBP/USD
  • New exchange rate: 1.2446 GBP/USD
  • Original cost in GBP: $10,000,000 / 1.27 = £7,874,015
  • New cost in GBP: $10,000,000 / 1.2446 = £8,034,709.95

The increase in cost due to the unfavorable exchange rate movement is £160,694.95, directly impacting the gross margin of the business. If they can’t adjust their prices or find other cost-saving measures, the impact on profitability for the year could be substantial, especially if the rate continues to trend against them.

Maintaining Profit Margins

To prevent such losses, companies often adjust their budgeted exchange rates throughout the year, monitoring currency movements and repricing products accordingly. This dynamic approach helps maintain profit margins even in volatile exchange rate environments. However, in highly competitive industries, relying solely on this strategy could significantly affect market position. Here’s why:

  • If the Exchange Rate Moves Against You: Without hedging, you might need to increase product prices to maintain profit margins, potentially making products less competitive, especially if competitors have hedged their currency risk.
  • If the Exchange Rate Moves in Your Favor: While favorable movements can increase profit margins, relying solely on them is risky and can remove predictability from earnings forecasts.

When determining an exchange rate for the year, it’s important to consider hedging and base it on concrete factors such as volatility and fundamental predispositions of where the exchange rate is heading, removing guesswork from setting a costing level. At Rutland FX, we assist with this using methods outlined further in this guide.

By implementing robust currency costing practices, SMEs can effectively manage currency risk, like mega-cap corporations. This proactive approach ensures that international operations remain profitable and sustainable, even in volatile currency environments.

How to Assess Currency Volatility with Three Methods

When managing currency risk, understanding and assessing exchange rate volatility is crucial. Volatility refers to the frequency and extent of price movements in the foreign exchange market. Here are three methods to evaluate currency volatility:

Method One: Returns Distributions

Returns distribution refers to the statistical analysis of how frequently a currency pair’s returns occur over a specific period. This analysis offers insights into currency return behavior but does not consider the price movements between these returns. Graphically represented, returns distribution swiftly indicates whether a currency pair or asset follows a normal or abnormal distribution, crucial for understanding underlying volatility and risk. Analysing returns distribution helps determine the standard deviation of returns, aiding in assessing the likelihood of large moves persisting or reverting to the mean.

Returns distribution analysis also illuminates tail risk, the probability of extreme events at the distribution tails. These rare but impactful events can significantly influence the market. In a normal distribution, such tail events are infrequent and less severe, while in an abnormal distribution with fat tails, extreme events are more common and severe. Understanding tail risk is vital for effective risk management, enabling businesses and individuals to anticipate and prepare for unlikely yet impactful market movements.

By correctly interpreting returns distributions, one can more accurately set costing levels using a data-driven approach, eliminating guesswork about potential exchange rate movements. At Rutland FX, we often provide our clients with reports like this to set realistic expectations for upper and lower bounds an exchange rate may move over certain time frames.

Method Two: Average True Range (ATR)

The Average True Range (ATR) serves as a technical tool for measuring currency pair volatility by averaging price ranges across a specified period. In contrast to returns distributions, which concentrate solely on open-to-close data, ATR encompasses open, high, low, and close data to capture actual price fluctuations within each trading period. It calculates the true range by considering the current high minus the current low, the absolute value of the current high minus the previous close, and the absolute value of the current low minus the previous close.

Averaging this data over a chosen period, typically 14 days but potentially longer, such as 1 week or 1 month, ATR provides a comprehensive view of volatility, including intraday highs and lows and gaps between trading periods. This understanding helps investors better grasp price dynamics and potential volatility risks, enabling informed decision-making and effective risk management strategies.

By combining ATR with Returns Distribution analysis, one can glean significant and precise insights into currency movements. For instance, if a significant movement in a particular direction appears to be a standard deviation move based on both volatility assessments, it informs a decision that the rate may revert to the mean.

Method Three: Implied Volatility

Implied volatility (IV) stands as a forward-looking metric derived from option prices on a currency pair, providing insights into the market’s anticipated future volatility. Typically expressed as an annualised percentage, IV signifies the expected degree of price fluctuation in an asset. For instance, an implied volatility of 6% implies the market foresees a potential 6% up or down movement in the asset’s price. Moreover, IV can be further dissected into shorter time frames, such as monthly, by dividing it by the square root of the period, offering finer granularity in volatility assessment.

In contrast to backward-looking indicators like Average True Range (ATR) and returns distribution, IV integrates upcoming catalysts such as interest rate decisions and major economic events, alongside historical volatility assessments. Market makers meticulously analyse these factors to compute IV and predict forthcoming asset volatility.

For example, ahead of an impending central bank meeting or significant economic announcement, IV may soar as traders anticipate heightened price fluctuations. This anticipation of future market movements is invaluable for businesses and individuals navigating currency markets, furnishing crucial guidance for crafting hedging strategies and managing risks. As IV mirrors the collective expectations of traders, it emerges as a valuable tool for foreseeing and adapting to future market conditions.

By amalgamating these backward-looking and forward-looking volatility assessments, one can develop a comprehensive volatility profile of a currency pair or any asset. This holistic approach enhances decision-making processes, enabling more informed and proactive responses to market dynamics.

 

Applying Volatility Assessments to Currency Management

By utilising these three methods to evaluate currency volatility, businesses can make more informed decisions in managing their currency risk:

  • Set Appropriate Hedging Levels: Higher implied volatility might prompt more aggressive hedging to lock in favorable rates and protect against adverse movements.
  • Upper and Lower Bounds: Understanding volatility aids in gauging the upper and lower bounds a currency pair may trade over a certain time frame, enhancing trade timing.
  • Plan for Market Movements: Regularly monitoring volatility assists businesses in anticipating and planning for significant market movements, facilitating proactive risk management.

While volatility assessments serve as a valuable quantitative tool, it’s crucial to recognise that exchange rates are also driven by fundamental economic factors. Therefore, a balanced approach integrating qualitative assessments, such as analysing economic data and trends with an emphasis on leading indicators, is essential. This comprehensive approach ensures a well-rounded perspective in currency management, avoiding the pitfalls of solely relying on quantitative metrics.

How to Get a Better Rate Than Your Corporate Bank

Traditional corporate banks can indeed be cumbersome for SMEs due to bureaucratic hurdles and convoluted procedures, resulting in frustratingly slow response times. SMEs often find themselves caught in a labyrinth of paperwork and administrative processes, causing delays in accessing essential financial services.

We’ve all experienced the frustration of calling our corporate bank, only to be transferred from one department to another. Moreover, within the intricate web of banking operations, decision-making can appear shrouded in mystery. SMEs are frequently left in limbo, uncertain about the progress of their applications or the status of their transactions. This opacity further compounds the challenges faced by SMEs, hindering their ability to plan and execute financial strategies effectively.

Adding to the complexity are the hidden fees and charges associated with currency exchange services offered by traditional banks. SMEs struggle to decipher the true cost of these services, as banks often bury additional charges within the fine print. This lack of transparency leaves SMEs vulnerable to unexpected expenses, eroding their profit margins and hindering their financial stability.

Furthermore, the traditional banking model often imposes long waiting times and hefty fees for opening multi-currency accounts. SMEs seeking to expand their global footprint encounter barriers in accessing these accounts promptly and cost-effectively. However, fintech companies like Rutland FX offer a refreshing alternative by providing instant account opening with no fees once your have completed an initial onboarding. This streamlined approach empowers SMEs to swiftly establish multi-currency accounts, enabling them to seize international opportunities without the burdensome delays and costs imposed by traditional banks.

In addition to these benefits, fintech companies often provide more personalised customer service. Unlike traditional banks, where you may find yourself endlessly transferred between departments, fintech firms offer dedicated support teams that understand the unique needs of SMEs. This personalised service not only saves time but also ensures that SMEs receive tailored advice and solutions that can significantly enhance their financial management and planning.

 

Why Use a Currency Exchange Specialist?

Currency exchange specialists offer better exchange rates than traditional corporate banks. These specialists have access to wholesale currency markets and can provide more competitive rates, resulting in substantial savings for businesses involved in international trade. Generally, currency exchange services can be conveniently managed through an online platform or with the help of a dedicated account executive:

  • Online Platform: We at Rutland FX can provide you with a user-friendly online platform that allows you to get real-time quotes, execute spot FX trades, and manage your multi-currency accounts all in one place, enabling you to handle your currency transactions efficiently and securely.
  • Dedicated Account Executive: For businesses that prefer personalised service, Rutland FX provides access to dedicated account executives. These professionals offer tailored advice, assist with complex transactions, and ensure that you get the best possible rates. Having a dedicated point of contact can make navigating the foreign exchange market simpler and more effective.
Example of Savings

Consider an SME that needs to convert £100,000 to USD to pay a supplier. A corporate bank might offer an exchange rate of 1.25 GBP/USD, whereas Rutland FX may offer 1.27 GBP/USD. The difference in rates might seem small, but it adds up significantly:

  • Corporate Bank: £100,000 * 1.25 = $125,000 USD
  • Rutland FX: £100,000 * 1.27 = $127,000 USD

In this example, using Rutland FX results in an additional $2,000 USD, demonstrating the substantial savings that can be achieved with more competitive exchange rates.

Advantages of Using Currency Exchange Specialists
  1. Better Rates: Access to more competitive exchange rates leads to significant cost savings.
  2. Flexibility: Options to hold funds in a multi-currency account, transfer to your account, or send directly to suppliers.
  3. Security: Funds are safeguarded in tier-one banks, ensuring high security, in the case of Rutland FX funds are Safeguarded by our FCA Authorised payment service provider Currency Cloud.
  4. Transparency: Clear and transparent quoting process, so you know exactly what rate you are getting before you commit.
  5. Convenience: Manage transactions via an online platform or with the help of a dedicated account executive.

By leveraging the services of currency exchange specialists like Rutland FX, SMEs can achieve better rates than those offered by corporate banks, improving their overall financial efficiency and competitiveness in the global market.

How to Use Limit Orders to Maximise Currency Management

Using limit orders can be a powerful tool for SMEs to optimise their currency management. A limit order allows you to set a target exchange rate at which you want to execute a currency exchange, offering a strategic approach to buying or selling currency at favorable rates.

What is a Limit Order?

A limit order is an instruction to buy or sell a currency pair at a specific exchange rate or better. It ensures that you only transact at your desired rate, providing a higher level of control over your currency exchanges.

Example: An SME with Flexible Payment Terms

Consider an SME that imports goods from Europe and has flexible payment terms with their suppliers. This flexibility allows them to wait for favorable exchange rates before converting their GBP to EUR.

Using Volatility Assessments to Set a Target Rate
  1. Historical Volatility: The SME reviews past exchange rate movements to understand the range within which GBP/EUR has fluctuated over recent months.
  2. Implied Volatility: They check the market’s expectations for future volatility, which provides insight into potential rate changes.
  3. Average True Range (ATR): They use ATR to gauge daily price fluctuations, helping them understand the current volatility levels.

Based on these assessments, the SME determines that a favorable exchange rate would be 1.17 GBP/EUR, compared to the current rate of 1.16 GBP/EUR.

Advantages of Limit Orders
  • Strategic Planning: Limit orders allow SMEs to plan their currency exchanges strategically, taking advantage of favorable rates.
  • Cost Savings: By executing trades at better rates, businesses can save significantly on currency conversion costs.
  • Time Efficiency: Once set, a limit order automatically triggers when the target rate is reached, eliminating the need for constant monitoring.
Potential Limitations

While limit orders can be highly effective, there are some limitations to consider:

  • No Guarantee of Execution: If the market does not reach the target rate, the limit order will not be triggered. This means there is a possibility that the exchange may not occur within the desired timeframe.
  • Market Volatility: In highly volatile markets, the rate might fluctuate widely, potentially missing the target rate by a small margin.

How to Use Forward Contracts and the Correct Way to Approach Them

Forward contracts are a key tool in the arsenal of currency management for SMEs. They allow businesses to lock in exchange rates for future transactions, providing certainty and protecting profit margins from adverse currency movements. However, it’s important to approach forward contracts with the right mindset.

Not About Speculation

Let’s start with a light-hearted reminder: forward contracts are not about trying to outsmart the market or moonlighting as a hedge fund manager. Instead, they are about securing your profit margin and ensuring you can stick to your budget.

The Purpose of Forward Contracts

Forward contracts allow you to fix an exchange rate for a specified amount of currency on a future date. This helps in:

  • Locking in Profit Margins: By securing an exchange rate, you protect your profit margins from unfavorable currency movements.
  • Budgeting Certainty: Knowing the exact exchange rate in advance helps in accurate budgeting and financial planning for the year.

Example Strategy: Hedging 75% of Exposure

One common strategy is to hedge a significant portion of your exposure, say 75%, while leaving 25% flexible for spot trades or limit orders in the event the rate moves against you. This approach offers a balance between security and flexibility:

  • Hedge 75%: By locking in the rate for 75% of your annual exposure, you ensure stability and protect the bulk of your transactions from volatility.
  • Flexible 25%: The remaining 25% can be managed using spot trades or limit orders. This allows you to take advantage of favorable rate movements if they occur.
Tailoring the Strategy to Your Business

The exact proportions you choose to hedge can vary based on your business’s risk appetite and annual volume of transactions. For instance:

  • Higher Risk Appetite: Businesses willing to take on more risk might hedge only 25-50% of their exposure, keeping a larger portion flexible.
  • Lower Risk Appetite: Conversely, more risk-averse businesses might prefer to hedge 90-100% of their exposure to maximise stability.

Example of Forward Contract Usage

Consider an SME that expects to pay $1 million to a supplier over the next year. The current exchange rate is 1.27 GBP/USD. By using a forward contract, they can lock in this rate for the entire $1 million, ensuring they know exactly how much they will pay in GBP.

  • Without Forward Contract: If the rate moves to 1.25 GBP/USD, the cost increases, potentially impacting profit margins.
  • With Forward Contract: By locking in at 1.27 GBP/USD, the SME protects against this risk and ensures consistent budgeting.
  • What if the Rate Improves?: If the rate improves, you are still locked in at the lower rate. However, instead of viewing this as a loss, it should be seen as guaranteeing your costs.

Some businesses may prefer to hedge 100% of their exposure to eliminate any uncertainty. This approach is particularly useful for highly risk-averse companies or those operating on very tight margins where any adverse movement could have significant impacts.

Forward contracts for businesses are not about speculation but about securing financial stability and ensuring predictable costs. The right approach to using forward contracts depends on your business’s risk appetite and financial goals. Whether you choose to hedge a portion or the entirety of your exposure, the key is to use these contracts to protect your profit margins and support effective budgeting.

What Economic Indicators Matter More Than Others

When it comes to making informed currency decisions, understanding which economic indicators to focus on can make a significant difference. The key is to distinguish between leading and lagging indicators. The price you see for an exchange rate, or any asset, generally incorporates all known information, often with a 6-to-12-month time horison into the future. Large movements in asset prices usually occur when new information enters the market or the general expectation did not happen. Markets are forward-looking, caring more about the future than the past. Thus, to effectively manage currency risk, it’s crucial to use leading indicators rather than lagging ones.

Leading Indicators

Treasury Yields and Interest Rate Expectations
  • What They Are: Treasury yields, particularly the spread between short-term and long-term yields, offer insights into future inflation and interest rate expectations.
  • Why They Matter: These yields indicate investor sentiment regarding future economic conditions. For example, an inverted yield curve (where short-term rates exceed long-term rates) may suggest expectations of an economic slowdown or decreased future inflation. Additionally, the yield differential between two countries can influence currency inflows and outflows.
Manufacturing PMIs (Purchasing Managers’ Index)
  • What They Are: PMIs are surveys of purchasing managers in the manufacturing sector, providing a snapshot of the economic health of the manufacturing sector.
  • Why They Matter: PMIs are leading indicators because they reflect new orders, inventory levels, production, supplier deliveries, and employment. High PMI readings above 50 indicate expansion usually with a 12-to-18-month time lag.
Industrial Production
  • What It Is: Measures the output of the industrial sector, including manufacturing, mining, and utilities.
  • Why It Matters: It’s a leading indicator of economic health because it shows changes in production levels, which can signal shifts in economic activity and demand for currencies.
Building Permits and Mortgage Approvals
  • What They Are: Building permits are authorisations for new construction projects, while mortgage approvals reflect the lending environment.
  • Why They Matter: Both are leading indicators of future construction activity and economic growth. A high number of building permits suggests a robust housing market and economic expansion.
Commitment of Traders (COT) Reports
  • What They Are: These reports provide a breakdown of the positions held by various traders in futures markets.
  • Why They Matter: COT reports can sometimes be used as a leading indicator by showing the positioning and sentiment of major market players, which can forecast future market movements.

Lagging Indicators

GDP (Gross Domestic Product)
  • What It Is: The total value of all goods and services produced over a specific time.
  • Why It’s Lagging: By the time GDP figures are released, the market often already has a good idea of where GDP will be based on leading indicators. Therefore, GDP figures typically confirm trends rather than predict them.
Unemployment Rate
  • What It Is: The percentage of the labor force that is jobless and actively seeking employment.
  • Why It’s Lagging: The unemployment rate is a lagging indicator because it rises or falls in response to economic conditions that have already occurred. High unemployment may persist even after an economy begins to recover.
Retail Sales
  • What It Is: Measures the total receipts of retail stores.
  • Why It’s Lagging: Retail sales data is often reflective of past consumer spending behavior and economic conditions, making it a lagging indicator.
Corporate Earnings
  • What It Is: Reports on the profits generated by companies over a specific period.
  • Why It’s Lagging: Corporate earnings reflect past business performance and economic conditions rather than future trends; however, earnings reports contain forward-looking statements which can be used as a leading indicator.

Summary

When managing currency risk, it’s imperative to consider both leading indicators and a combination of qualitative and quantitative factors to anticipate market movements and make well-informed decisions. At Rutland FX, we specialise in analysing these factors daily, serving as a supplementary treasury service for businesses. By leveraging our expertise, we can significantly enhance your currency risk management strategies and safeguard your bottom line.

At Rutland FX, we diligently examine various elements such as treasury yields, interest rate expectations, implied volatility, and currency exchange rate movements. We meticulously assess economic data, geopolitical events, and market sentiment to provide valuable insights into future currency movements. This comprehensive approach enables us to offer tailored solutions to mitigate currency risks effectively.

For SMEs with limited resources and time, we at Rutland FX serve as a valuable partner, alleviating the burden of analysing complex market dynamics. By entrusting these tasks to specialists, businesses can streamline their operations and focus on core activities while ensuring robust currency risk management practices.

In essence, partnering with Rutland FX not only provides access to expert analysis and guidance but also offers peace of mind, knowing that your currency risk exposures are being diligently monitored and managed. This collaborative approach empowers businesses to navigate currency fluctuations with confidence, ultimately with the aim of contributing to sustained growth and profitability for your business.

Still not sure?

If you are still unsure or have any further questions, please call us on 0203 026 0112 or request a callback to discuss your requirements.