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For importers and exporters, especially, movements in the Australian Dollar can mean the difference between a profitable month and an average one. John Corcoran explains why keeping an eye on the dollar is so important and suggests ways for businesses to protect themselves against foreign exchange risk

As any importer and exporter can tell you, fluctuating exchange rates often have a direct impact on your bottom line. And depending on your activities, as you keep a watchful eye on the changes, sometimes the news will be good, sometimes not so good.

Many factors affect exchange rates, however the Australian dollar has been extremely sensitive to recent movements in commodity prices. The dollar has benefited from a strengthening world commodities market, particularly the rising price of precious metals such as gold and silver, and base metals such as copper. The rise in the value of these commodities is of direct importance to Australia because we are a major exporter of raw materials, especially gold and copper. This has seen an increase in demand for Aussie dollars as overseas commodities buyers seek to pay Australian suppliers.

Calculating Risk

Big companies dedicate entire departments specifically to manage currency risk because they know it’s vital to the business’s success. But no matter the size of your business, whether you’re an importer or an exporter, there are many reasons why you should be aware of currency movements, but the most important, and obvious, reason is that it can cost you a lot of money if you don’t.

For example, suppose you are an exporter and you’ve priced your largest order of the year at US$100,000 based on an exchange rate of 0.7300. You are expecting to receive a payment of A$136,986. However, the Australian dollar has appreciated by the time you receive payment and the new exchange rate is 0.7800. Consequently, the amount you eventually receive is A$128,205 and the difference to your bottom line is $8,781. That’s an extra $8,781 worth of profit you’ll have to work for, or find somewhere else. It doesn’t make sense to take that risk.

As exporters are usually paid foreign currency that eventually needs to be converted into Aussie dollars, they benefit from a strong foreign currency and a weak Australian dollar. When our dollar is weak, it results in more money for the sale of goods overseas.

In the world market most transactions are made in US dollars, euros or, historically, in Japanese yen. Although the Australian dollar is one of the world’s major currencies, you would be hard-pressed to find many international clients who would be happy to buy goods or services in Aussie dollars. In fact, pricing your products in US dollars can be a competitive advantage, as it simplifies the transaction for your customers. However, these exporters will have an exposure to movements between the Aussie dollar and the greenback. The word ‘exposed’ is appropriate, as the fluctuations can be significant. This was evident after the recent rise in the Australian dollar rate from US70 cents to US78 cents (more than 11.5 percent)† in only two months, which means an exporter would have been receiving 11.5 percent fewer Aussie dollars in export earnings over that period.

An importer faces a different scenario but the exchange rate risk is equally significant. For example, as an importer, you price your products to clients based on the calculations that you made at the start of the year. You have sent away for samples, ordered your next shipment, prepared for trade shows, and the orders are flowing in so fast you have to order more to keep up with demand. In the meantime, however, you haven’t noticed the exchange rate has dropped from US75 cents to US70 cents (as it did in March 2006)—and it’s only been three weeks since you ordered the goods! You come to do your end-of-month calculations in expectation of a great month with all the new orders and, somehow, the numbers show it was only an average month. Where’s the answer? It lies in the extra dollars you had to put into those payments for your supplier in China, that ended up costing six percent more than you originally anticipated.

Then it’s a struggle to make up for the loss down the line. In an industry where profit margins are being continuously squeezed, if you change your prices some of your customers may cancel, while others will complain that you can’t do business and may not return. If you don’t adjust your price, then it would mean another couple of months worth of profit straight down the drain, and no business can afford that.

Solutions At Work

There are several tools that businesses can use to take advantage of fluctuations in the dollar. By being prepared, businesses can use ‘limit orders’ to lock in a specific exchange rate should the market fluctuate to their desired level. The importer or exporter can nominate an exact exchange rate, place an order to transact at that rate with their foreign exchange (FX) provider, and if the market reaches that price they can then automatically lock the rate in. Given the FX market operates 24 hours a day, the customer can often lock in advantageous exchange rates while they are sleeping or busy growing their business.

To minimise the risk of volatile exchange rates, a popular hedging tool is the Foreign Exchange Contract (FEC). A FEC allows a business to lock in present exchange rates for future payments to suppliers (for importers), or for conversion of foreign currency back into Australian dollars (for exporters). For example, if you had a payment of US$100,000 coming up in a few months, you can remove the exchange rate risk by locking in the rate now. Suppose the outright rate for three months forward is 0.7650, this means the total payable in three months time would be A$130,718.95 regardless of future fluctuations in the exchange rate. A FEC eliminates currency risk for a business and allows them to accurately forecast and report profit margins.

There is so much information about foreign exchange that it can quite often be overwhelming for SMEs to digest and implement the correct strategy. The banks have traditionally been the main suppliers of FX, but businesses are increasingly using regulated foreign exchange dealers for advice and service on their FX needs. For example, businesses can speak with a licensed dealer to get current updates of the market and what events could affect your payments in the coming days. Once you are comfortable with the rate, then you can either initiate the transfer immediately (called a ‘spot’ transaction) or take out a forward contract to lock in today’s rate for payment at a future date.

Be Prepared

Looking ahead, OzForex expects another volatile year for the dollar. Due to recent developments with commodity prices, many analysts are now revising their previous forecasts. At the beginning of 2006 many were predicting an Australian dollar value below US70 cents, and this certainly looked likely when it reached a low of 0.7015 at the end of March. However, since then roaring commodity prices and a weaker US dollar across the board saw the Aussie bounce back to 0.7800.

Much of the commodities demand is being driven by China’s economic expansion, which is expected to continue over the next five to 10 years.

We think the underlying demand for Aussie dollars will continue for the remainder of 2006, with dips expected to be limited to around 0.7200.

It’s in your company’s best interest to plan ahead, by estimating as accurately as possible your total foreign currency payments for the next six to 12 months. It’s also recommended you lock in FECs (for importers this would be between 0.7600 and 0.7800) to cover those future payments. This will give you peace of mind knowing exactly what your cost base will be for the year ahead. You will then be able to predict future profits more accurately and plan the expansion of your business with more certainty.

Given the relatively positive outlook for the Australian dollar, it would make sense for exporters to lock in some forward rates on dips towards 0.7200.

Moves of this magnitude are not unusual. The New Zealand dollar has declined in value against the Australian dol
lar by 19 percent since December 2005.

*John Corcoran is a currency analyst with commercial foreign exchange dealer, OzForex, www.ozforex.com.au

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