Because of globalization, the way all businesses operate, regardless of size, has changed significantly. As these businesses become larger and enter new markets, they turn towards the global playing field in order to find opportunities both to purchase goods and to sell their own products and services. Essentially, as consumers compare the market by going to different stores to find the best deals, businesses compare the globe to find their own. And this means they also have to understand currency exchange rates.
Although a consumer looking at the price difference on an item between Target and Walmart is very easy, it is a little bit more complex for businesses. Consumers simply have dollars to spend and they determine where they can spend the fewest dollars for the most products. But when businesses compare prices on the international market, they have to take into account the currency exchange rates in order to determine where their products really are the most affordable in the international market. This means that they also have to have an understanding of foreign currencies, and what the risks associated with that currency are. There are fantastic benefits to working together with companies in countries all over the world, but there are significant risks as well.
Take, for instance, consumers who want to purchase a lawn mower. They have US dollars to spend and can take these dollars to either Walmart or Target and pick their mower. But the manufacturer of that mower, who may have $500,000 to spend, cannot simply take those US dollars into Hong Kong for the electronics, South Korea for the engineering, and China for the materials. They must, instead, work together with a foreign currency broker to exchange the right amount of those $500,000 into the correct currency for each of the countries that they work with. This also means that, each day, they could have a greater gain or loss because the currency exchange rates fluctuate significantly. As a result, profit margins are potentially different each and every day, too.
Understanding Gains and Losses Due to Currency Exchange Rates:
In the most simplistic way, gains and losses are caused by changes in the foreign currency rates. This, in turn, is influenced by a great deal of different factors, including interest rates, inflation, geopolitical events, and natural disasters. The political stability of a country, however, is perhaps the greatest impacting factor. A lot of companies don’t understand the Forex (foreign exchange) market, which is understandable since it isn’t their business. But the danger of that is that they instead rely on recent trends and ranges, which can turn into a significant pitfall and trap. Businesses that want to operate on a global market have to gather as much information as they can about currency exchange rates. Additionally, they must understand each of the factors that have an influence on these rates and analyze whether or not they have been a factor on a specific day. The added difficulty in this is that the global market runs 24 hours a day, because of the various time differences. Each minute, there could be changes in the rates, and staying on top of that takes real skill.
Of course, there is a lot to be learned from historical data. However, assuming that history will quite literally repeat itself is not the right thing to do. There are many other factors that can be of importance. For instance, imagine a company in this country that had entered some sort of agreement with a company in India in 2013. In months January to the middle May of that year, the rate for the Rupee (the currency in India) was 4% or below. Suddenly, between months May and July, there was a 28% depreciation in the Rupee. Had the company in this example not anticipated this, considering only the historical data that set the rate at 4%, it could have cost them a great deal of money.
Protection Against Currency Exchange Rates:
So is it possible for businesses to survive in this highly complicated global economy, considering how volatile it is? The simple answer is that it can. There are numerous hedging tools that exist to help businesses mitigate the risks to a degree. Forex forwards and options, for instance, are good examples of this and they make profitability projections and cash flows far more predictable.
Additionally, it is generally recommended to take out exchange contracts denominated in foreign currency. This is known as a “forward exchange contract”, which essentially means that the two parties involved agree on an exchange rate for a set period of time, regardless of how the Forex market behaves. These contracts are legally binding and can only be canceled by mutual agreement. This is a great way for both parties to protect themselves against inflation and deflation.
Another form of protection is to take out an option in foreign currency. This means that buyers continue to have the right of exchange at specific future times. This rate is also specified at the start. However, the buyer can withdraw at any point. This means that the contract is somewhat more flexible for the buyer, who has to pay a broker for this privilege. These contracts are a great way to have some degree of insurance against currency rate fluctuations.
Mitigating exchange rate risks is possible, although it does require some specialized knowledge. It is vital, therefore, that any business that ventures into the global market to put measures in place to protect themselves, for instance by working together with hedge firms or other financial specialists. Consulting with experts is always recommended.
Currencies and economies alike never stand still and change continuously. They can be very volatile because they depend on so many different external factors. Hence, any company that wants to work on a global level should hire a CPA (Certified Public Accountant) with knowledge of the international market, and also with risk mitigation skills as they pertain to foreign exchange.