How exchange rate volatility affects businesses trading overseas
The combined forces of globalisation and advances in technology means the world has become increasingly interconnected over the last few years. For small to medium sized businesses (SMBs), it has opened a new marketplace beyond domestic borders to sell products and a market from which to source materials at a competitive price.
But there are also challenges. Trading overseas involves navigating the sometimes-difficult arena of global regulations that surround trading activities and the import and export of products. Understanding various foreign markets and their respective cultures is another.
What is often overlooked, however, is how currency exchange rates, fundamental to international transactions can affect a business trading overseas.
What are currency exchange rates?
In simple terms, the rate at which one currency can be exchanged for another is known at the exchange rate.
For example, if the euro to Pound sterling rate is 0.88, then 1 euro is worth 0.88 pence sterling. This also means that 0.88 pence sterling will buy you one euro.
An increase in the value of the euro will buy you more foreign currency meaning you can purchase more for the same amount of money.
Exchange rates are constantly shifting, even from minute to minute and often quite dramatically.
In 2022, many global currencies were driven to historic highs and lows because of the Russia/Ukraine War, combined with massive inflation and post Covid 19 monetary policy.
Some of the most impacted currencies were the United States dollar (USD), euro (EUR), British pound sterling (GBP), Japanese yen (JPY) and Russian ruble (RUB).
What other factors cause currency exchange rates to fluctuate?
There are a few factors that influence exchange rates and any business trading overseas should be familiar with each.
The global financial marketplace sets exchange rates. Banks and other financial institutions trade currencies based on these factors which include inflation, balance of payment data and Public debt amongst others.
How exchange rates affect your Business
Let’s look at how exchange rates can affect your business when trading overseas.
- Pricing: The cost of goods will always be higher for an importing business if the domestic currency is weaker. Conversely, a strong domestic currency means the cost of goods will be lower for an exporting business.
- Profits: Exchange rate volatility also affects your business’ profitability. if you are exporting a product or providing service in a foreign country, a change in the exchange rate will have a direct impact on your bottom line.
- Competitive Advantage: Competitiveness in the global market is another factor to consider. A company’s products will be more expensive relative to the competition if the domestic currency is weaker. The converse of this is that the stronger the domestic currency, the cheaper a company’s products will be giving it a competitive advantage.
- Investment: If your business is planning on making an investment overseas, exchange rate volatility can impact your ability to determine the return on investment
Let’s look at a situation where exchange rate volatility affects a business trading overseas from a buying and selling perspective.
Buying goods overseas
Does your business contract with a supplier from a foreign country? If so, you become vulnerable to fluctuations in the exchange rate.
As an example, let’s say that a UK based manufacturer regularly sources materials from the United States. The business invoices its supplier in US dollars.
In 2022, the pound fell sharply against the dollar, and on 26th September GBP/USD registered an all-time low of $1.03.
So, if the manufacturer had to pay an invoice of $100,000 in August 2022 for goods purchased the same month, he would be doing so at a rate of 1.1721, costing him £85,317. However, the same shipment would have cost him £96,637 had he paid the invoice a month later at the prevailing rate of 1.03, an increase of £11,320.
By utilising the services of a business foreign exchange specialist, the manufacturer could protect his bottom line by fixing the exchange rate with a forward contract, reducing the risk to the business.
Selling goods overseas
Sterling’s depreciation against the euro in 2022 had not been as severe, given the European Union’s own challenges with economic slowing and energy supply.
Supposing the same manufacturer arranged to sell £100,000 worth of goods to a buyer in Ireland. The Irish buyer will pay in euros and the goods are payable within 90 days. The manufacturer notes that the euro is worth 1.15 today so basically, he is selling his goods for €115,000.
The pound reached a high of 1.1964 against the euro in 2002 and if after 90 days it reached a similar level, the manufacturer would have got the price he contracted for plus 4,000 in profit.
If on the other hand, the euro strengthened against the pound and reached 1.1136 (as it did in 2022) at the date of payment, the manufacturer would have received almost 4000 less when converted back into pounds.
How Fexco can help
The COVID-19 pandemic, Russian-Ukraine war and subsequent global inflation issues have led to greater uncertainty around currency volatility. Businesses are under pressure to protect the bottom line but with currency markets in constant flux, forecasting is becoming increasingly more difficult.
Fexco can help your business with a currency risk assessment and advice on future exposure. We will advise on the best risk management tools you can use, like forward contracts to reduce or avoid any losses resulting from volatile exchange rates. We can also advise on estimated costs and savings for future international payments.
Speak to one of Fexco’s currency dealers today and discover how you can mitigate currency risk and save on your international payments.