FACTSHEET
International Trade and the Foreign Exchange Markets
This information sheet will be useful if you buy or sell products in a foreign currency,
have assets or plan to have assets overseas and also for those who have a need to
manage their exposure within foreign currency.
Introduction
The Foreign Exchange Markets are far reaching, diverse and volatile. This diversity
spans everything from trading in Goods and Services right through to usage in loans
and speculation. For any Organisation whose operation involves buying and selling
currency, a clear understanding of the processes and tools available and the impact
currency movements can have is essential.
Why is it Important?
The Currency markets are arguably the most volatile of the markets and large fluctuations
can occur on a daily basis. For example, on a £100,000 transaction against a 2%
movement in the currency will move the buy price or sell price of the given product
or service by £2,000. The currency markets trade 24 hours a day and are influenced
by political and economic events. Whilst it is impossible to predict exactly what
will happen in the future, a healthy understanding of what tools are available and
how they can be applied can prevent unnecessary losses on currency transactions.
Purchasing currency is based primarily on two main types of contract; Spot contracts
and Forward contracts.
Spot and Forward Contracts
The
Spot Contract is the most basic and commonly used foreign exchange product.
It is an agreement to buy or sell one currency in exchange for another. You have
2 days to settle the contract, at a price based on the prevailing "spot exchange
rate" the current value of one currency compared to another. Although the spot market
lets you buy or sell currency as you need it, spot exchange rate movements are highly
unpredictable, even during a single trading day. Upon receipt of cleared funds currency
is available for onward transmission. A
Forward Contract lets you buy or
sell one currency against another, for settlement no later than on the day the contract
expires. Unlike spot contracts, a forward contract eliminates the risk of fluctuating
exchange rates by locking in a price today for a transaction that will take place
in the future (up to a maximum of 2 years). Most importantly it protects you from
unfavourable movements in the market, however, be aware that it will not allow for
gains to be made should the exchange rate move in your favour during the period
between entering the contract and final settlement for the currency. A forward contract
does offer the flexibility to take delivery of your currency before the expiry date
of the contract. Often a deposit is required (10%) to secure the contract and is
payable within two working days with settlement due on the day the contract expires.
A forward contract is particularly useful for Importers and Exporters as it offers
the purchaser the ability to budget precisely for the medium term and forecast without
having to gamble and estimate against the fluctuations of the currency markets.
Risk
If you are an importer or an exporter you will find yourself exposed to an easily
identifiable form of exchange risk. This risk manifests itself in the need to buy
or sell currency relating to a transaction in return for Sterling. Movements in
the exchange rates can work in your favour and increase profitability,
but,
equally they can also work in the opposite way and seriously damage and erode your
profit margin or worse still create a loss.
A less obvious form of risk but still equally relevant is where an overseas client
pays in Sterling. If Sterling strengthens too much it may make your products or
services too expensive and affect your competitiveness. Therefore by choosing to
use Sterling abroad you are just passing the Foreign Exchange risk to your clients,
but will still face the same effects of a changing market.
Managing Risk
With an understanding of the risk involved when dealing with Foreign Exchange you
are better placed to consider how to best manage that risk. The key ways are as
follows:
Do Nothing – This high risk strategy means relying solely upon a spot contract
and one won’t know the rate of exchange achievable until the actual point of buying
the currency. The volatility and unpredictability of the currency markets makes
this strategy high risk and speculative. The markets do move both ways, so it could
result in a win (or lose) situation, however it does make budgeting for the future
virtually impossible.
Secure a Forward Contract – This will enable you to lock into a rate of exchange
the moment you know you have a currency requirement in the future. It will protect
you against any market movement, both positive and negative and you will know exactly
how much the transaction will cost you. Securing a forward contract with the broker,
at higher level of exchange than that agreed with the supplier/purchaser will ensure
a profit margin on the exchange rate alone. The benefits extend to being able to
calculate budgetary forecasts for at least the term of the Forward contract.
Use Currency Options – The two key tools are a Stop Loss order, which will
protect you against adverse exchange rate movements and secure your currency if
it falls below a pre-agreed level. The other is a Limit order, which is placed at
the top end of the market to secure currency at a specific price that may not be
currently available. This type of contract is particularly useful when the markets
are moving in a positive direction for you.
The best option for managing currency risk will be different for each organisation
as they will have their own specific requirements, limitations and flexibility with
which they can reach to.
Please contact the
Foremost Currency Group to discuss your Foreign Exchange
requirements, the options available and to gain an insight into the Currency Markets.
