If you’re importing, chances are you need to buy foreign currency on a regular basis. Naturally this currency exchange becomes yet another risk factor in your business which you must mitigate.
Big businesses have access to exotic systems for managing currency exchange risk, among which is a financial product called the forward currency exchange contract. As a small importer, it is possible in certain situations for you to use this method to manage currency risk, too — but before doing so you should be aware of the facts.
A forward contract is an agreement between you and a currency dealer to purchase a certain quantity of foreign currency at a certain price on a certain date. For example, you might agree to buy 950,000 Japanese yen for 12,195.88 US dollars on November 11th of this year.
Once you enter into this contract, you are obligated to make that purchase when the appointed time comes. If the exchange rate has changed in your favor, you will be losing money. On the other hand, if the rate has gone against you, you will be delighted to have had the wisdom to arrange the forward contract. In that case, you will be getting a better rate than if you had bought the currency in the spot market.
It’s important to understand that a forward contract is not meant for speculative purposes, since it is largely impossible to predict currency exchange fluctuation. Indeed, the purpose of the contract is to remove the need to speculate on where the exchange rate will go.
With a contract rate firmly locked in place, you can focus on more important aspects of your business. You will be able to sleep at night knowing you won’t lose your shirt if the currency markets turn against you.
So where do you go to get a forward contract? A quick search on the Internet might give you the impression that a bank would be the logical place.
Not so. Walk into a bank and ask your banker about forward contracts, and you will be rewarded with a smirk.
The banker knows that a forward contract is for medium and big businesses that are managing millions of dollars. And you’re not part of that club.
Generally speaking, a forward contract is not an appropriate solution for managing currency risk at the small business level. So, before continuing with forward contracts, let me point out two simple ways to manage currency risk without resorting to a forward contract.
First, you can just buy what you need in advance. Let’s say you are about to place an order with a lead time of 90 days and you’re anxious about where the exchange rate might be headed in the interim period. If you have extra cash on hand, you can simply buy what you need in advance and stash it in a bank account for when the final payment is due.
Second, you can price the currency risk into your profit margin. Looking at historical rates, you know that the currency pair has not fluctuated more than 10% over the previous 12 months. If your markup is 100%, you can live with a 10% change in the exchange rate. Chances are very good that it won’t make a move large enough to erase your profits. And, on the upside, you have a 50% chance the rate will move in your favor, thus improving the profitability of your shipment.
So, before going with a forward contract, ask yourself whether simply buying the currency in advance or pricing currency risk into your markup will be sufficient to mitigate currency exchange risk for your business. Both methods are effective when you are dealing with a foreign currency that is relatively stable with respect to your home currency.
Nevertheless, there are contexts when you might need a forward contract. Certainly one of its uses comes when you must make a payment in a currency that fluctuates wildly — say, because of political risks such as war.
Another situation which calls for a forward contract is where your profit stands to be wiped out by an unexpected fluctuation. (If this is the case, you should ask yourself whether it is wise to take this level of risk for such a small potential reward.)
If you find yourself needing a forward contract, by all means use one. But don’t go to the bank asking for one, as you’ll just be rebuffed.
Instead, you can get a forward contract through an online Forex service. These online services are geared to small international traders, and they will be more than happy to sell you a forward contract where a bank would not normally do so.
I’m not going to endorse any particular service. There are many of them out there — just do an Internet search for online forward exchange contracts and you will find what you’re looking for.
An online Forex service is the best way for small businesses to buy a forward contract. They’re also better for spot purchases than a conventional bank as well.
But before you jump in and buy that forward contract, just remember that it is a contract. If the market moves in your favor, you will end up paying more than the spot price.
That’s the price you pay for the peace of mind of a forward contract.