Companies that do business internationally have to navigate a complex web of risks that can affect their profitability on every deal, and one of the biggest of these is currency risk.
If your business gets paid in foreign currency, the value of that deal can be dramatically affected based on changes in the value of that currency. The value of foreign currencies constantly fluctuates based on a wide variety of factors ranging from monetary policy, to economic trends within countries, to the results of the latest election.
Below, Mike Quintanilla, FX Director at First Horizon Bank, discusses currency risk, how it impacts companies that do business internationally, and what you can do about it.
What are some big picture trends related to foreign exchange (FX) and currency risks for companies that do business internationally in 2017?
Mike Quintanilla: A few years ago, people in my line of work were focused on the global recession, Greek insolvency, quantitative easing, and the related risks of inflation or deflation. Now the bigger focus is on geopolitics. Never before has the subject of geopolitics been the main driver of the FX markets. FX rates in the short term are mainly driven by speculative flow and news events. For example, the euro had a lot at stake with the 2017 French presidential election. If far-right candidate Marine Le Pen had been elected, the euro would have had a big problem. The French election polls have played into EURUSD prices.
Long-term trends are more influenced by economic fundamentals such as GDP output, monetary and fiscal policies, trade balances, and interest rate differentials. Currencies perform relatively better in countries with strong growth, sound economic policies, and a free market environment. Additionally, FX rates are driven by commodities. Commodity prices influence the value of major oil exporters' currency — if the price of oil goes down, the value of the currency of those major oil exporting nations tends to go down, too.
What should international business owners do to manage their currency risks?
Stay informed about the latest trends affecting the markets where you do business. First Horizon Bank provides weekly “International News & Views" reports on what the markets are doing, how political situations are affecting the value of currency, and more.
And, beyond that, with international deals and currency risks, you don't want to have to react to a situation after it happens — you always want to be prepared.
One of the most common strategies, hedging, is a technique that allows people to manage risks and avoid losses due to currency fluctuations, and it's a way to be proactive instead of reactive. Hedging isn't just used with foreign currencies, however. Bonds markets, equities markets, commodities markets — all markets can use hedging to protect themselves against rate-averse fluctuations.
Hedging is an important strategy for international business owners because the currency exchange rate in any country can change drastically.
If you're doing business outside the United States, you want to look at ways to limit your exposure.
For example, the Brexit vote was a huge surprise to lots of people all over the world. When the U.K. voted to leave the EU, the pound dropped 12 percent within 24 hours. That's a big move! Any assets for an American business in the U.K. immediately lost 12 percent of their value in one day, just by the change in currency valuation. So, as an international business that owns assets in other countries, you want to hedge yourself against that sort of risk.
Can you give us some examples of hedging strategies?
One example of how to hedge your currency risk is an FX forward contract, which can be used to lock in the exchange rate for payables, receivables, or any transaction anticipated on a future date. No cash changes hands until the time the contract matures. A forward contract guarantees the U.S. dollar value of a future business commitment.
For example, let's say an exporter based in the U.S. won a contract to sell €10,000,000 worth of widgets to a European distributor with six-month payment terms. If the American exporter is worried about the euro depreciating, they can lock in the current forward EURUSD exchange rate, which locks in their profit margins.
You can also hedge your currency risk with FX put and call options. These give the buyers the right — not the obligation — to purchase or sell a currency at a specific exchange rate during a set time. The buyer pays an upfront premium for this right. Put and call options protect against downside risk, but preserve all upside moves.
First Horizon Bank's International department offers tools you need — market research, currency forecasting, and technical analysis — to formulate a hedging strategy to help safeguard against volatile currency fluctuations. Members of the International department want to help you be proactive, not reactive, and establish more revenue certainty for your FX transactions. When your business works with a team like First Horizon Bank, they can help strengthen your foundation to conduct international business in foreign currencies.
Learn more about First Horizon Bank's International Business Solutions.