How to Use Currency Hedging to Protect Your Import or Export Business

One of the biggest risk factors involved in operating an importing or exporting business is that while your sale is in progress the value of a foreign currency may change relative to the value of the U.S. dollar. This means some of your export profits can get lost in translation.

Overseas buyers typically pay in their own currency, which is then exchanged for dollars before it’s deposited in your bank. Here’s an example: You thought you were going to get $500,000 for that shipment of wooden chairs your company exported to France. But by the time your goods make their way overseas on a barge and the buyer takes delivery, the dollar has weakened against the euro and you end up only getting $460,000.

On the flip side: Instead of weakening, the dollar strengthens suddenly against the currency your buyer uses. By the time your merchandise arrives, it costs the buyer more in the local currency to equal the dollar value you agreed upon, and now the buyer doesn’t want to take delivery and close the sale.

As you can see, currency fluctuations can really take a bite out of your profits. That’s why savvy exporters and importer’s use currency hedging to protect their companies from the risk of changing currency values. All the big retailers that operate internationally use currency hedging to make sure their profits aren’t eroded by currency changes, and small businesses can do it, too.

There are several ways to hedge currency.

Foreign Bank Account

If you’re an importer and need to purchase merchandise abroad, one currency protection method is to simply open an account in the country you are importing from. When the exchange rate is favorable, send U.S. dollars to your foreign account for deposit. The bank will change them into the local currency.

Now the money is locked into the other country’s currency and ready to spend. The downside here is it’s hard to time currency fluctuations.

Currency Forward Contract

Major banks offer currency forward contracts, which are essentially an agreement to exchange certain amounts of dollars for foreign currency on a future date. This allows you to lock in an import purchase or export sale at the current exchange rate , guaranteeing your transaction at the agreed upon price.

Of course, if the U.S. dollar strengthens afterward, you can’t profit from it; you’re locked into an exchange rate. But you have protected your business from the risk of a weakening dollar.

Futures Contract

Similar to forward contracts, futures are a commitment to purchase currency in the future at an agreed upon rate based on current exchange rates. You should purchase currency futures contracts from a reputable exchange such as the Chicago Mercantile Exchange or London International Financial Future Exchange.

Futures contracts have one important advantage over forward contracts: There is a secondary market for them, so you could opt to sell your contract before the term is up if you change your mind or your business needs the cash. On the other hand, futures contracts usually allow a range of final exchange prices rather than a fixed point, so you may not get the exact exchange rate you want when the contract hits its maturity date. Also, the contracts are only offered in fixed amounts, which may make it hard to hedge the exact amount you want through futures.

Currency Options

Banks offer currency options, which give you an opportunity, but not an obligation, to buy or sell a set amount of currency at a set price, on or before a chosen date. Options come with a “strike price,” the price at which the currency can be bought or sold, and an expiration date, after which your opportunity to purchase at the agreed upon price ends.

In essence, futures and options allow you to bet on where currency prices will go. You lock in at a rate you’re hoping will be at least as good as the actual rate when the contract or option comes up.

An important drawback to note about contracts and options is that each of these currency-hedging strategies comes with fees and commissions charged by the bank, exchange, or other party administering the hedging vehicle. Weigh those costs to your business in evaluating whether you want to hedge currency.

Source : https://www.allbusiness.com