Foreign exchange is one of the most volatile markets in the world, with millions of participants across the globe exposed to currency fluctuations 24 hours a day – Jim Vrondas suggests a couple of solutions for businesses to stay one step ahead.
In the foreign exchange market, just about everyone is attempting to do the exact same thing: get the best exchange rate possible on their currency transfers. That means timing the transfer to coincide with the absolute highest price in the market at the time, which can be quite a difficult, if not impossible, task.
Many business owners spend far too much time glued to the computer screen watching the market move every second, and attempting to predict future movements. These are the same people who make very important decisions for corporations and are often swayed by emotion and tempted by risk, just like any of us.
It’s important to remove oneself from the emotional attachment and not let these feelings drive our actions. Businesses should always have a plan that allows them to take advantage of any positive fluctuations when they’re not watching the market, especially given most of the volatility in foreign exchange rates occurs during European and US business hours.
Many small business owners often feel disappointed at having missed out on a good exchange rate overnight, while they’ve been asleep. Take, for example, Harry who works for Hindsight Manufacturing. Harry is responsible for paying overseas suppliers for the import of stock from China and regularly sends US dollars to pay them, so he is constantly monitoring the fluctuations in exchange rates. He knows he will have to send US$50,000 in the next day or so and sees the rate at 0.7700 today but believes the rate will improve overnight and decides to hold off purchasing the currency today. Harry believes it will cost him fewer Australian dollars tomorrow when the rate improves. The next morning Harry checks the rate only to find that after having traded as high as 0.7800 during US business hours, it is now trading at 0.7650. He tells himself, ‘if only I was awake at the time I would have bought the US dollars at 0.7800’. Of course this appears easy in hindsight, however picking the top in the market is near impossible. Had Harry used the services of a foreign exchange provider that was open 24 hours, he may have been able to capitalise on the rate increase overnight.
A common way to capture these movements is through the use of limit orders. Placement of a limit order means you specify your desired exchange rate and should the market price fluctuate to that level, your foreign exchange provider will automatically purchase the currency for you. While this is a common practice among share brokers, it is harder to find among currency brokers.
Harry may not have placed a limit order at 0.7800 but he may have had one in the market at 0.7750 or 0.7780, in which case he would have locked in a rate above the 0.7650 opening price the next morning.
Another way to make the most of volatility is through the use of forward contracts. A forward contract allows you to buy or sell a specified amount of foreign currency at a forward exchange rate for settlement at a specified future date—it’s a kind of ‘buy now, pay later’ contract. The forward contract ‘locks in’ the foreign exchange rate for a future date, eliminating the effect that fluctuations have on your bottom line over that period.
Harry does some forecasting and discovers he will need to send US$200,000 over the next three months to cover various shipments from different suppliers. He can remove the foreign exchange risk over this period by purchasing a forward contract that matures in three months. The benefit of this approach is Harry knows exactly what it will cost him in Aussie dollars over the next three months to pay his suppliers. Let’s assume he can get an outright three-month forward rate (his exchange rate for three months from today) of 0.7700 for the US$200,000. This equates to a cost of A$259,740.26, regardless of exchange rate movements over this period. So even if the rate falls to 0.7500 it will still cost him the same amount of Australian dollars and, in this example, it would mean a saving of A$6,926.41.
There are many other benefits in this approach but above all it allows businesses to not only manage their cash flow better, but can help businesses make the most of the volatility by capturing unusually high rates. In fact businesses can combine the use of both limit orders and forward exchange contracts. For example Harry could leave a limit order with his foreign exchange provider to buy US$200,000 as a three-month forward.
Limit orders and forward exchange contracts have traditionally only been available to the big end of town—organisations with foreign exchange turnover in the tens of millions. However, foreign exchange providers such as OzForex watch limit orders and also executes forward contracts for small to medium enterprises. With a 24-hour dealing desk based in Sydney and London, OzForex continuously monitors the market around the clock, enabling them to lock in exchange rates for their customers no matter what the time of day or night.