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How to Avoid the Most Common Pitfalls when Managing Currency Risk

Who is this guide for?

  • Business owners considering expanding into offshore markets
  • Business owners who already buy or sell in international markets and have lost money
  • Business owners / CFOs who lie awake at night worrying about currency movements and their profit impact

International markets can provide exponential growth for businesses by way of broadening either the supplier or customer base.

But the increase in risks can also be substantial because now your profits are exposed to a highly volatile and seemingly uncontrollable force: the exchange rate.

The AUD/USD typically trades in a 14c range each year. 

Of course, 2020 being an extraordinary year on most fronts, it also saw the AUD/USD trade in a 38c range.

On December 31, 2019, the AUD traded at a high of 0.7032 before collapsing to 0.5509 on March 19 and then retracing to 0.8007 on February 25 2021. Daunting price action in anyone’s language.

While we don’t get 30c moves every year, we do see 14 -20c moves each year, so how do you avoid letting this impact your profit margins?

Let’s look at the most common pitfalls facing business owners when dealing with the currency.

Most of the pitfalls detailed below arise from the following:

Top 5 Pitfalls Most Businesses Make when dealing with Currency Risks

  • Not understanding your own risk preferences
  • Not fully understanding your cashflow or payment schedule
  • Considering the currency as an after thought
Pitfall 1: Disconnect between currency purchases and requirements

Understanding your cash flows is generally relatively straight forward. 

The difficulty arises when expanding into the international markets as this takes time.

As a result, there are often lumpy international payments or receipts.  If you are making foreign currency payments, you at least have some control as to the timing. Bear in mind though, that if you delay payments until you get a “good” rate, you risk alienating your new supplier.

Selling to international markets is somewhat more problematic.  You are now at the mercy of your customer as to when they pay as well as when the bank finally transfers the funds to your account.

A word of warning to recipients of foreign currency funds: banks will often automatically convert foreign currency into AUD at retail rates.  So, you will have no control over the rate at which the funds are converted.  You will need to make sure you have a “Do not convert” instruction in place.

Pitfall 2: Reacting to market price action (Speculating)

Speculating is perhaps the most dangerous of all the pitfalls and it can come in two forms.

The first is epitomised by the concept of a “good” exchange rate.

The first question is good compared to what?…yesterday’s rate, the rate you got last time you made a payment, better than what the forecasters predicted? 

The only thing that really matters is that it is better than the rate you have used to set your selling price or your budget or target rate.

If it’s not, then you have eroded some of your profit margin.

The second type of speculating occurs when you think the market is going to move against you and you start taking large positions. 

If the market does collapse, then you might call it risk management but it is really luck. 

Of course, if the market moves in the opposite direction then you have a large amount of currency to use up. 

If you haven’t matched it against your cashflows, you may find that you have given up considerable profit opportunities to protect the risk of a downward movement or worse, you have more currency than you need.

Pitfall 3: Measuring your payment rates against the spot rate

This follows on from Pitfall Two.

And it generally happens when there have been large single directional currency moves (also known as impulsive moves).

Rather than benchmark against your budget rate, you want to budget against the spot rate.

Three things happen here. 

First, you are not measuring your profit accurately.  If you have set a rate to determine your selling price, then any rate that is better than that is an increase in profit margin and vice versa.

Second, if you find that the spot rate is better than rate you booked some time ago, your will likely move towards Pitfall 2 and start buying when the rate is “good”.

The third thing that happens is complacency.  If you fell that you are doing better by “picking the market” then you won’t be ready for the turn, which in currency markets is inevitable.

Pitfall 4: Confusing Factual Information with Advice

In the main, it is almost impossible to get specific advice tailored for your business from banks or brokers.  There is usually a General Advice disclaimer either before you start talking with them or after. 

This means they are not taking your specific requirements into consideration.  It might feel like they are, but they are not.

So, it is up to you to evaluate the risks and benefits of the information they provide. 

Pitfall 5: Counterparty Diversification

Counterparty diversification is often overlooked and generally for a couple of reasons.

First, it’s easy to deal with only one bank or broker.

And two, many businesses still hold to the idea of building relationships with their suppliers, whether it’s a bank or any other supplier.

However, using only one counterparty has the following drawbacks:

  • It leaves you open to a change of heart by your bank which means you would have to either close your FX positions or move them
  • If you wish to change to another bank or broker, you have to close or move your FX positions
  • If your business grows substantially, you might run out of available limit and so can only buy in the spot market

Of course, if you have only small requirements, then it probably doesn’t make any sense to have more than 1 counterparty, but as your business grows, it’s another risk to be considered.

Each of these pitfalls can be easily avoided.  With a tailored risk management programme all the critical elements of your currency risk can be addressed, leaving you to focus on the growth of your business.

What’s the next step?

If this article has piqued your curiosity and you’re keen to explore further, then the next step is to set up a time to conduct a complimentary Currency Risk Management Overview session, either by digitally or in person.

We’ll review and evaluate your risk profile as well as your current risk management approach and work with you collaboratively to create a plan to manage your currency exposure(s).

If you enjoy the conversation and find it worthwhile, we can discuss working together.

On the other hand, if what we come up with isn’t quite what you were hoping for or you feel we are not best placed to assist you with your currency requirements, then that’s okay too – at least you’ve looked at what else is available.

To take the next step, call us on (03) 9415 7353 or complete the Contact Form:

https://www.interfinanz.com.au/contact/

Whatever you do, I hope that some of the ideas in this guide help you to understand and manage your exchange rate risk more effectively.

Thank you for your upload