Exchange rate is defined as the value of one currency for the purpose of converting into another. Whilst the is a simple idea to comprehend, its implications when it comes to business and international trade are humongous. In this article we will investigate the role foreign exchange rates play in the viability and operations of a business.
How does a change in the currency valuation of your home country affect your business? How does the valuation of the currency in a country you’re exporting / importing materials or products from affect your business? These questions will be answered in detail and you’ll get a good idea of how foreign exchange rates and the overall market health can influence the trajectory and profitability of your business.
Before doing so, it would be wise to take a look at the reasons affecting the value of a currency. Why are currencies so volatile? What are the core reasons behind their constant fluctuations?
The higher the interest rates within a country, the stronger the currency. Higher interest rates will naturally attract foreign investment, growing demand and value of the home country’s currency. High interest rates attracts money to flow into a country and therefore strengthen its value.
This is a simple inference to make as a stronger economy will always be the backbone of a strong currency. A country with a strong and steady economic growth will normally see its central bank increase interest rates as a way of managing inflation. The impact of increasing interest rates was outlined on the section above this one.
These are some basic components affecting the behaviour of currency. The full list of elements is long and elaborate and probably the subject of another blog post. For now, let’s revert back to answering the question asked in the title.
The implications of dealing with foreign exchange rates can be huge for the CFO of a company. Loans, assets and liabilities must all adhere to the same financial language and the ever-changing nature of foreign exchange rates is not the most helpful thing. Financial statements undergo a lot of scrutiny and they are an essential building block for a company that wants to be taken seriously.
This is the most clear-cut scenario showcasing how fluctuations in exchange rates can severely affect a business. Exporting goods overseas means that your cost of producing goods and the price of selling them will come in two different currencies. What this means is that your business is in for some serious profits or equally, some devastating losses.
Imagine you own a UK company where you import products from Europe. If the UK Sterling Pound to Euro rate increases, you will find yourself making more money without altering your prices. Using the same scenario, if a company exports products, their exports will become more expensive and unprofitable in the long run.
These principles do not just apply to businesses that import / export finished products. A lot of companies need to import raw materials to produce their products. This is a case where the entire business is influenced.
The price of fuel is not just a concern for your monthly household budget. If a country is importing fuel from abroad, a shift in the market exchange rate can prove to be detrimental for the entire economy and therefore local businesses. If the local currency depreciates there will be an overall increase in the cost of transportation meaning that the transportation of goods will take an immediate hit.
Tourism is a prime example of how currency depreciation affects business. Countries like Greece, Cyprus and Spain base a sizeable chunk of their economies on tourism. Once their currency depreciates, they immediately become a favourable destination for travellers since they can now get more value for their money. Exchanging their money to the home country’s currency will buy them better accommodation, food and overall leisure activities. Even though depreciation of a currency is generally seen as a bad sign for a country’s economy, there are indirect benefits to be derived by businesses from an increase in tourism.
Mergers and Acquisitions
Businesses are assets and just like every asset, they have a price. On periods where currency is depreciated, businesses are devalued and become optimal candidates for a merger or acquisition. International companies with a stronger currency are more likely to explore the option of buying or merging with a company whose currency is depreciated.
Ways to Safeguard Your Business From Exchange Rates Fluctuations
Leaving your business at the mercy of the exchange rate volatility is a dangerous game. There’s a multitude of reasons as to why exchange rates can shift. From politics and government policies to natural disasters and economic boycotts/embargoes, there’s a lot that goes into determining exchange rates. What do all of those factors have in common? The fact that you, as a business, have no real power or control over them.
Having said that, there are different ways you can resort to in order to protect your business from the unpredictability of exchange rates. Let’s investigate.
Fixed contracts are exactly what it says on the tin. Contracts that shield your business activities from the unforeseeable nature of exchange rates. The contract outlines exact prices for imported / exported materials or finished products over a specific time period. This set of stipulations ensures that your business projects are immune to the ups and downs of exchange rates.
Buy in Bulk
This is obviously a strategy that can’t be employed by all businesses because it all depends on the kind of products / services your business deals with. By buying in bulk, you secure more units of a product than you actually need in order to make the purchase at an exchange rate that is favourable to you. Think of an airline company buying fuel for example. What makes business sense is to buy as much fuel as they can when the exchange rate suits them the best. If they buy based on a short term need-buy basis, they are exposing themselves to the unpredictability of exchange rates.
Exchange rate vulnerability was one of the first conundrums that financial technology tried to resolve. The result of that effort? Payment platforms such TransferWise, WorldRemit and WorldRemit. These FinTech wonders essentially solve the issue of international business payments. By paying a small upfront fee, you can send money overseas using the mid-market exchange rate. Orders are executed within the same day in contrast to slower service by local banks and give you the stability you need to plan, forecast and not fret over exchange rate fluctuations.
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