In every economy no matter how large or small, companies face many risks that can have significant impact on their operations and their bottom line.
For companies importing their prime product from foreign markets, things can get a bit more complicated as they will also have to deal with risks associated to buying and selling in international markets.
Protecting Your Company Against Currency Risk
One of the financial risks for companies that buy their products from foreign markets is currency risk; which arises when their local currency loses value against the foreign currency in which they have to meet their obligations or collect their receivables.
Currency risk or exchange risk will affect any company that buys or sells in other markets.
The impact that this risk can have in their business can be significant, especially in developing economies where the devaluation of the local currency can double their cost in a short period of time and where the local prices tend to adjust at a much later time due to local production or the availability of products that can substitute theirs.
Protecting your company against currency risk should be in the mind of every CEO and CFO of any company that buys and sells in a foreign currency.
Although protecting against currency exchange could be a complex process, this can be obtained by implementing a simple strategy.
It should always be kept in mind though that the purpose of a risk protection strategy is to minimize your exposure of fluctuating exchange rate for your currency, not to try to increase your bottom line thru the possible gains resulting from this activity.
The main goal in implementing a protection plan is to minimize your exposure and to do so one should try to fix your exchange rate at the time of the purchase or the sale.
This can be obtained among other ways trough prepayments and currency hedging.
The prepayment strategy is without a doubt the simplest form of protection for any company.
It is exactly as it names suggest, if you are buying you pay cash at the moment of the purchase and if you are selling you sell in cash at the moment of the sale.
The down side of this is that you are adding pressure to your cash flow management at the moment of the purchase because you are prepaying for a product that you do not have immediately due to transit and delivery times.
The up side of this transaction is that if your currency devalues, you would have purchased your product at a lower price in local currency. However, the opposite will happen when your local currency appreciates, you would have paid more in local currency and collect less local currency on your sales.
The second option, also very simple, is a currency hedging strategy. Unlike prepaying, it does carry a premium that has to pay and will require working in collaboration with your financial institution or a brokerage company that deals currency hedging.
Another difference between prepaying and using this strategy is that you do not have to put the added pressure to your cash flow because you do not have to buy the currency at the moment of your purchase.
Simply put, currency hedging is the process buying a foreign currency at a pre-set exchange rate in the future. This eliminates the risk of your currency devaluing too much and you having to pay as much as double or more in local currency.
This strategy has some risks, the first one would be that you currency stay the same or gains value, in this case you do not have to buy the option at the exchange rate you fixed; you would only loose the premium you paid to buy the option.
However, if your currency devalues and the exchange rate is higher than the exchange rate you bought, your savings in local currency can be significant.
Planning and protecting your company for exchange rate risk is a smart way to minimize your possible losses.
Making the decision to implement a risk strategy will depend solely on your assed risk and exposure to the fluctuations of your currency.
No matter what, always try to make an informed and educated decision.