Currency Conversion Issues
Currency conversion can be costly.
If your business does business with international companies you must deal with sometimes-complex currency conversions.
Even small businesses now routinely operate in global markets, and the relationship between the dollar and many major currencies has reached new levels of volatility.
In the past two years, one of the most watched international rates — the euro versus the U.S. dollar — has swung wildly, from as high as $1.60 to the euro to as low as $1.25. As recently as 2002, the euro was worth 85 cents. The Canadian dollar has strenthened significantly in recent years.
Despite burgeoning deficits and an economy that could grow slowly for the next few years, the United States has, somewhat surprisingly, reclaimed its long-standing role as the world’s safest currency.
With such volatility in key exchange rates, how can small business owners protect their companies from the risks of currency conversions? Here are some options:
Share the Risk: Perhaps the most straightforward way to eliminate or reduce currency risk is to structure the business so that revenues are earned and expenses are incurred in the same currency. Then, if a company sees declining revenue due to currency shifts, it can offset some of the impact with correspondingly lower costs.
Contract Design: Addressing possible currency fluctuations through contract design is another relatively simple and efficient strategy. Your customer can agree to a minimum amount of committed business for a specific period of a contract. Your business can then hedge that risk using financial instruments for the life of the agreement. If the customer wants to terminate the contract early, it agrees to cover the cost of unwinding the hedge. Most customers are understanding, in part because they realize that they will still make money, even after accounting for potential currency-related adjustments.
Hedging: Consider currency risk from the very beginning of every contract. Develop a financial hedging strategy for the life of the program. Factor in the expense of executing the
Hedge your currency bets.
necessary hedging contracts with your bank or financial institution before quoting a price. Train your finance and accounting staff to make sure that everyone understands the accounting and reporting requirements for hedging activities. Small companies are starting to explore the possibility of hedging through derivatives, according to Sanela Hodzic, director of strategy and business development at Calypso, a developer. The decision to engage in financial hedging depends not only on a company’s own risk profile but also on its competitors’ positions. If everybody has got hedging programs except you, you need to think seriously about putting a program in place, because it’s really going to impact your competitive situation in a volatile currency environment potential future upside should the euro strengthen significantly. Finally, a CFO could lock in the company’s foreign-exchange rate by putting a forward contract on its cash flows at a certain rate; if the rate later goes up, the firm does not gain.
Conclusion: Regardless of whether a CFO feels he or she can dive into the complex world of financially hedging a company’s foreign-exchange exposure, it is clear that the time is right to review currency liabilities and develop contingency plans, because the uncertainty in the dollar and its relationship with other currencies is not going away any time soon. Future currency trends are very difficult to predict.