Business is being done globally more than ever before. With this opportunity for businesses comes the task of managing foreign exchange risks. Currency fluctuations can significantly impact the profitability and financial stability of companies operating internationally.
This article explores the intricacies of the foreign exchange market, the effects of forex on businesses and strategies for effectively navigating currency fluctuations.
What is the foreign exchange market?
The foreign exchange market, or ‘FX’ market, is a global decentralised market for the trade of currency around the globe. It is the largest and most liquid financial market in the world, with over $6 Trillion traded on the market daily.
The forex market is open for 24 hours a day, closing on the weekend while being open five days a week. However, it’s most active and volatile at certain times during the day. The most active times are the Tokyo, London and New York sessions, in line with the different time zones.
How does the forex market work?
The forex market works through a network financial institutions and banks that trade on behalf of other businesses and corporations. Businesses and traders alike can trade through platforms such as Tradu, using analytical tools to follow the forex market and make informed trades.
Currencies are traded against each other in pairs, with the relative value of one currency to another being evaluated by supply and demand. The most commonly traded currency pairs on the foreign exchange market are called major currency pairs, these include the pairs EUR/USD, GBP/USD and USD/JPY.
Factors influencing currency exchange rates
Several factors influence currency exchange rates. The most notable include economic indicators (such as GDP growth, inflation and employment data), interest rates, political stability and general market sentiment.
Central banks also play an important role by implementing monetary policies designed to influence national economies, but that can also affect the value of their respective currencies.
How does foreign exchange affect businesses?
Foreign exchange rates can have a significant impact on your business if you’re engaged in international trade. These risks can include:
Risks during transactions
Transaction risk impacts businesses between the point of entering a contract and settling it. If you agree to sell to a customer in another country who is paying in a certain currency, any change in the value of that currency against your own before the payment is made could result in higher or, more worryingly, lower revenue.
Accounting exposure
Accounting exposure, or translation risk, could pose a threat if you have foreign subsidiaries and a parent company integrating financial standings. Fluctuations in exchange rates can affect reported earnings, assets and liabilities, leading to uncertainty and volatility in financial statements and potential wider impacts.
Long-term economic factors
Operating exposure is the long-term effect of currency fluctuations on your company’s market value. For example, a stronger domestic currency can make exports more expensive and less competitive in the global market. This can ultimately reduce your market share and profitability without strategic intervention.
How to navigate currency fluctuations internationally
Effective management of currency fluctuations is crucial if you’re to minimise risks and protect profitability. There are a range of strategies you can use as a business to navigate these challenges.
Hedging strategies
Hedging is a common technique used by businesses to mitigate forex risks. You may want to consider:
- Forward contracts: A forward contract locks in an exchange rate for a specific date in the future, providing more certainty about the cost of future transactions.
- Options: Currency options allow the trader to exchange money at a predetermined rate before a specified date, allowing them to profit from favourable exchange rate movements while reducing risk of losses.
- Futures: Currency futures are standardised contracts traded on exchanges, similar to forward contracts, but with more liquidity and transparency. They can be used to hedge against potential losses from exchange rate fluctuations.
Diversification
Diversification is another effective strategy used to manage forex risk. By diversifying markets, products and revenue streams, your business can reduce its exposure to any single currency.
For example, if your business can export to multiple countries, you can mitigate the impact of a decline in one currency and market by having revenue streams in several different currencies.
Operational strategies
You may also want to consider various operational strategies to manage currency risks, including:
- Currency invoicing: Invoicing in your home currency transfers the forex risk to a trading partner or customer. However, this might not always be feasible if it reduces your competitiveness.
- Natural hedging: This involves matching currency income and outgoings. For example, if you have significant expenses in a foreign currency, you can offset this by generating revenues in the same currency as protection.
- Flexible sourcing and production: By establishing production operations and supply chains in different countries and regions, your business may be more easily able to adapt to currency fluctuations.
Financial management and monitoring
Underpinning all the above should be effective financial management and continuous monitoring of exchange rates and economic indicators. These are crucial for informed decision-making.
Your business should develop robust risk management policies and utilise financial market analysis tools to stay informed about potential risks and opportunities.