Imagine two scenarios.
In the first, you’re a British business supplying mining equipment to a customer in Australia and in 90-days’ time you’ll be receiving payment for goods of 250,000 Aussie dollars.
And lets imagine for the sake of simplifying the calculation that the exchange rate for AUD/GBP at present is 0.50.
Based on today’s rate, you’re expecting to receive precisely GBP 125,000 pounds sterling into your bank account on the payment date.
Given your business’ outgoings, you don’t want to receive much less than GBP 125,000 and you are becoming more and more concerned that the AUD dollar might weaken against the British pound between now and the date you receive funds. There’s a general election coming up soon in Australia and the business columnist in the Wall Street Journal has said that the AUD dollar could fall by 10% if the incumbent party remains in power.
If the value of AUD falls 10% (to an exchange rate of 0.45), your business will receive only GBP 112,500, which is GBP 12,500 less than would be received at today’s rate.
In another scenario, imagine you’re buying a small business in Australia in 90-days. You’ve done due-diligence on a business and you know the date you’ll buy it. It will cost exactly 1 million AUD, which to you means a purchase of GBP 500,000.
Now, what if the AUD/GBP rate strengthens post-election to 0.55? Then you’d be looking at a cost of GBP 550,000, or GBP 50,000 more than you’d pay today.
Both of these scenarios describe the FX risk inherent in every future transaction made in a currency that is not your own.
Do not fret, however. Whether you’re receiving foreign currency or paying in it, are selling microwaves or buying a hotel, Best Exchange Rates’ partners can help you hedge your FX exposure using the following methods:
An FX forward contract is simply an agreement to change money with another party at a later date at the current exchange rate (the actual ‘forward rate’ has a slight adjustment to account for interest rate differences between the two currencies in play).
By paying a small deposit on the forward, businesses can lock in today’s advantageous exchange rate and then change their money at a time of their choosing – up to three-years in the future with certain providers.
Unlike FX options (see below), forwards offer no upside should the exchange rate move in a favourable direction.
You can more information on these contracts in our guide What is an FX Forward?.
An option contract gives the holder the right, but not the obligation, to exchange currency at a rate (“strike” price) of their choosing at a specified time in the future.
An option works in a way not dissimilar to your car insurance. When you insure your car you pay a premium to an insurance seller and if something bad happens (if the car is stolen or damaged) the insurer will pay out to compensate you for your losses. If nothing happens to your car then you’ve lost your premium but at least you lived with the knowledge that you were protected.
If the British business mentioned above bought a 3-month ‘put’ option (the business buyer would buy a ‘call’ option) on the AUD/GBP exchange rate with a strike price of 0.5, they would also pay a premium to the option seller (the seller of their FX “insurance”), and if the market fell to 0.45 (if something bad happened), they would be compensated by gains in the option.
These gains would be equal to the difference between the option strike price and the market price at the time of option expiration (0.5 – 0.45 = 0.05) multiplied by the amount of currency they had chosen to hedge with the option.
Unlike a car insurance policy, however, if nothing bad happened then the company would stand a chance to gain from upside movement in the exchange rate if using options. If, for example, the AUD/GBP rate strengthened after 90-days to 0.55, the British business would stand to receive GBP 137,500 from their customer – a welcome move that would more than cover the premium paid on their option.
If you are concerned that a future overseas payment is going to cost you more in the coming weeks and months due to an appreciation in the foreign currency’s value, then one of the simplest things you can do is to buy your foreign currency today instead of later. What more needs to be said? Funds can be deposited in interest bearing accounts or short-term investments until your payment date.
Best Exchange Rates’ online comparison calculator for foreign currency transfers allows readers to easily find the cheapest provider of foreign currency. Our providers don’t inflate their margins like retail banks and savings of 2%-3% in the total amount of local currency are common.
BER compares exchange rates from banks and FX specialists.
Disclaimer: Please note any provider recommendations, currency forecasts or any opinions of our authors should not be taken as a reference to buy or sell any financial product.