Foreign currency and exchange rate risks
If your business exports or imports goods or services, you need to consider how you will protect yourself and identify foreign exchange risks. Even a small variation in the exchange rate could cost your business thousands of pounds.
You'll also need to decide how to make and receive payments in foreign currencies.
This guide is aimed at businesses that regularly deal with customers who are based outside of the UK. It explains how to price goods or services, how to combat the risk of exchange rate changes and the practicalities of foreign currency transactions and bookkeeping.
Foreign currency issues when importing or exporting
Businesses which import or export goods need to bear in mind a number of key issues when making transactions in foreign currencies:
- Foreign currency transactions are sensitive to fluctuations in the exchange rate. A price you agree with a customer or supplier on one day could rise or fall if the exchange rate changes.
- If you're exporting, you must decide whether it's best to price your goods or services in the local currency of the country with which you're trading. The decision will depend on individual circumstances and on factors such as how you want to present yourself in that market and how your competitors set their prices.
- If you're importing components priced in a foreign currency that form part of goods you're selling in sterling, you'll need to decide how to price those goods to reflect the exchange rate.
- If you are trading with companies in the eurozone (ie the European Union member states that use the euro) there are many practices and standards to make life easier. See trading in the European Union.
Identify foreign exchange risks
When your business deals in a foreign currency you are exposed to certain risks.
For example, you might find that after agreeing a price for exported or imported goods the exchange rate changes before delivery. Clearly, this can work both for and against you.
Some currencies are more volatile than others because of their unstable economies or inflation. However, the current economic climate is also impacting more stable currencies such as the euro and the US dollar. Your bank should be able to advise you about this.
As exchange rates can go both up and down, it can be tempting to gamble that this will work out in your favour. However, this is extremely risky and could land you with a significant financial loss.
Insuring against the price of currency
It's safer to reduce the risk by using one of the forms of hedging available through a bank. Hedging simply means insuring against the price of currency moving against you in the future.
Hedging may be able to:
- protect your business from financial shocks
- make future cash flows more predictable
- improve your financial flexibility through prudent risk policy
There are many different types of currency hedging and your bank should be able to help you with the best solutions for your business. Other product providers may be available but you should be comfortable that you are dealing with a reputable and regulated organisation.
You could trade overseas in sterling - effectively transferring the foreign exchange risk to the business you're dealing with. Whether this is appropriate will depend on the product in question and the relative bargaining strength of you and your trading partner.
Bear in mind that exchange rates could have an effect on your business' competitiveness even if you don't trade overseas. When a country's currency loses value against the pound, imports from that country into the UK become cheaper, so you may have to respond to aggressive pricing from competitors who source from that country.
Similarly, if a country's currency gains value against sterling, UK exports to that country become cheaper.
Forward foreign exchange contracts
One way to hedge against exchange rate movements is to arrange a forward foreign exchange contract. This is an agreement initiated by you to buy or sell a specific amount of foreign currency at a certain rate, on or before a certain date.
Forward foreign exchange contracts are a secure and simple way of hedging when you're confident your deal will go ahead and the currency will be required.
Imagine you will need to purchase components worth €100,000 from a German supplier in 12 months' time. One euro might currently be worth 90 pence, meaning the supplies would theoretically cost £90,000.
However, if the euro increases in value against the pound to 95 pence over the year, the components would then cost you £95,000.
If the euro is expected to increase in value, you might agree a forward foreign exchange contract to buy €100,000 for £92,000 on a specified date. Of course, you'll lose out if the euro falls in value.
This solution suits almost all businesses that are at risk of losses stemming from adverse foreign exchange rates, especially those who:
- trade in a volatile market or to tight margins
- require large amounts of currency and so have a greater risk of losses resulting from unfavourable foreign exchange rates in relation to turnover
Advantages of forward foreign exchange contracts
- You're protected against any adverse movements in the exchange rate.
- You can set budgets knowing exactly how much the transaction costs.
Disadvantages of forward foreign exchange contracts
- You have to go ahead with the contract once you have arranged it, regardless of whether your circumstances change.
- Because the rate is fixed, you can't benefit from any favourable movement in the exchange rate.
Forward foreign exchange contracts can be arranged through all the major UK clearing banks or independent foreign exchange dealers and can be tailored to meet your specific requirements. Your bank or financial organisation should be able to advise you.
The cost of a forward contract is usually built into the exchange rate.
Banking overseas and UK-based foreign currency accounts
You may want to consider opening a foreign bank account to help manage your business' currency and exchange risks. Alternatively, most UK clearing banks offer euro accounts, as well as accounts in other foreign currencies.
Opening an account with a bank overseas could be beneficial if you will be making or receiving lots of payments in a foreign currency - especially lots of small payments.
The advantages of this could include:
- Because your money will be held in the local currency, you can wait for the exchange rate to become more favourable before converting it - as long as you don't need the funds immediately.
- A bank in the country with which you're trading will be fully conversant with the rules and regulations regarding transactions in that country, and your customers might prefer to deal with a bank in their own country and in their own language.
However, the disadvantages could include:
- An overseas bank may not offer the same level of protection and redress as a UK bank.
- Setting up an account overseas can be a long-winded process and some countries have complex rules on who is entitled to open and operate a bank account.
- You may experience communication difficulties.
UK-based foreign currency accounts
Foreign currency accounts can be a good option for importers and exporters as they allow you to 'net' receivables and payables in the same currency. This allows you to hedge against exchange rate changes by keeping money in the account until the rate is beneficial to you.
This solution suits businesses with:
- a large number of dealings in a particular currency
- a strong cashflow - which means they're unlikely to require immediate access to funds
- a need to hold currency for future payments
Using a foreign currency account based in the UK allows you easy access to your money while also allowing you to discuss transactions in English with your own bank.
However, there can also be some disadvantages to this, including:
- If you need to convert funds in your foreign currency account into sterling for UK use - eg to ease cashflow - you will face a loss if the pound is strong against that currency.
- You may also have to wait a long time for the exchange rate to move in your favour - and it may never do so.
- Banks tend to charge ongoing fees for these types of accounts.
Buying currency options
There are different ways of hedging your exchange rate exposure and your bank will be best placed to keep you updated with any new alternatives available.
Buying currency options is a more flexible form of hedging than setting up a forward foreign exchange contract - but it's also more expensive.
Currency options give you the right, but not the obligation, to buy or sell a certain amount of currency at a specific exchange rate on or before a specified date. But unlike a forward foreign exchange contract, you're not obliged to buy or sell the currency at the end of the period.
To enjoy this flexibility you'll have to pay premium. Fees will depend on the amount of currency involved, the exchange rate and the length of the option. Typically, in the region of 1 or 2 per cent of the face value of the contract and with a minimum fee of £500.
This option suits businesses that:
- want to protect themselves from unfavourable rate changes while retaining the flexibility to benefit from advantageous ones
- are entering into a deal but there's a fair chance of it not going ahead - eg a tender situation
- have a foreign exchange exposure in excess of £500,000 per trade, although this may vary between banks
Advantages of buying currency options
- You're protected from any adverse movements in the exchange rate.
- Your business can benefit if the exchange rate moves in your favour.
Disadvantages of buying currency options
- The expense of setting the option up.
- Only available to companies with large foreign exchange exposures.
The ability to buy currency options is offered by most of the UK clearing banks.
Foreign currency transactions and bookkeeping
Carrying out business transactions in a foreign currency will have an effect on your normal accountancy procedures since you'll need to convert foreign currency payments and deposits into sterling.
Accounting procedures are complex and you should take professional advice on your own circumstances. Generally speaking when you account for foreign currency transactions you should calculate the amount in sterling, using the exchange rate that applied on the day of the transaction.
Any foreign currency held, as well as any amounts of currency that you owe or are owed, should be converted into sterling using the rate in force on the date of the balance sheet.
If you make any gains or losses as a result of foreign currency transactions, you should include these in your profit and loss account.
Bear in mind that holding assets in a foreign currency will have an impact on your balance sheet since - owing to exchange rate movements - their value might differ radically from one year to the next.