Wednesday, September 30, 2020
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Dealing with Foreign Exchange in a New Business

It comes as quite a shock to some that so many new businesses have worldwide operations. In this day and age, globalization through e-commerce is an everyday reality for online businesses and their clients.

While the Internet of Things has facilitated the liberalization of commercial trading in goods and services, individual countries are less dynamic in terms of how these transactions are conducted.

Moves are afoot to further liberalize international monetary transfers by way of blockchain-based technology and cryptocurrency, but we are many years away from an international standard like that. The fact of the matter is that foreign currency transactions are a major component of international trade.

The Bank for International Settlements reported in 2016 that the foreign exchange market averaged approximately $5.1 trillion daily. While markedly lower than the $5.4 trillion figure from 2013, it dwarfs the value of all other forms of trade, and all other markets combined.

Such is the significance of forex that it is worth highlighting how businesses should be dealing with this extremely volatile market. Suffice it to say, cross-currency pairs are associated with whipsaw activity which can impact your business’s bottom line.

Consider the impact that Brexit has had on the GBP over time. In June 2016, after the Brexit referendum results, the GBP/USD exchange rate dropped to 1.21. Barely a few days before that, the GBP/USD was trading at 1.49.

For an American business expecting a set payment from a UK customer in the value of £100,000, the USD equivalent plunged from $149,000 to $121,000 overnight.

While the UK customer is still expected to pay £100,000 for the products or services to the US-based business, the business must bite the bullet to the tune of $28,000.

Needless to say, volatility in the forex markets can cripple businesses if precautionary steps have not been taken.

Why do Businesses Accept Forex if so Volatile?

As a business, particularly an online operation, it makes sense to cater to a wide audience of customers. The power of e-commerce is its global reach, limited only by courier services and their costs of delivery.

Businesses that operate online invariably work with forex on a daily basis. Any geographically-limited business activity inherently restricts overall profitability by dint of the fact that there is a global market to work with.

Businesses have several options when marketing their products to customers all over the world. They can set product pricing in a fixed currency such as USD, but by doing so they run the risk of alienating clients who may not want to be dealing with foreign currencies. There is way too much volatility in terms of price movements between the USD, GBP, EUR, CAD, AUD, ZAR, ILS, and other currencies. One workaround is to price products in local currencies for customers in specific geographic locations.

Businesses also purchase raw materials, supplies, and services from foreign-based providers. If this is the case, then the business is also engaged in foreign currency transactions.

There are several ways to lock in favorable exchange rates such as setting a standard for how pricing works. Rather than a fixed USD price for a US business, it may be better to have the price quoted in the local currency, given that the USD is the world’s reserve currency.

In any event, money will have to change hands from the buyer to the seller. This is where businesses lose a huge chunk of change.

Whenever currencies are converted, middlemen pad the spread and make it impossibly expensive for businesses to operate profitably without passing on these costs to consumers in the form of higher prices.

One option is to make the exchange by bank draft at a traditional banking institution. Unfortunately, this tedious process takes a long time to complete and is expensive.

Avoid PayPal at All Costs

Most everybody has heard of PayPal, or perhaps even used PayPal at some point.

PayPal gets the job done, but this money transfer/money exchange operator is extremely expensive with all sorts of fees, commissions, and unfavorable exchange rates in play.

PayPal has been enjoying top billing for many years, but truth be told it ranks among the most expensive ways to transfer money back and forth.

PayPal takes a cut out of everything, and the exchange rates they offer are nothing like the interbank rate, or even the rate you are likely to get at non-bank money transfer companies.

According to PayPal US, selling fees are 2.9% + $0.30 per sale. For international sales – and this is the clincher – PayPal takes a whopping 4.4% transaction fee plus a fixed fee based on the currency that is received. If a business is operating on low margins, PayPal is certainly not the way to go.

How Can Businesses Guard Against Forex Volatility?

Volatility is a real concern for online businesses. Forex rates are subject to whipsaw movements on a daily basis and this is to be expected given the 24/7 nature of currency trading.

A business that is trying to manage its costs will invariably want to lock in forex rates ahead of time to remove volatility from the equation. Certainty is possible when dealing with customers, suppliers, and stakeholders all over the world, and one of the ways to do this is known as hedging with options such as forward contracts.

As a powerful risk-management resource, a forward contract allows a business to buy/sell a currency pair such as GBP/USD for delivery on a future date, with a guaranteed exchange rate at that time.

A forward contract differs from a conventional forex transaction where a spot rate (the rate at the time) is charged. One can see where this is effective, especially when businesses are buying raw materials or supplies and anticipating costs in advance.

Likewise, a business that is selling high-end products needs to ensure that the proceeds from those sales will cover the costs and deliver the expected returns.

A currency forward rate contract can be taken out for up to 1 year in the future on average. These forward contracts are applicable to major currency pairs, and in the case of the GBP/USD or even the EUR/GBP, these contracts are available for up to 5 years.

The benefit of using a hedging tool like this is found in the cost savings. It’s relatively straightforward to take advantage of a forward contract particularly when there are price differentials between the spot rate and the forward rate. The forward rate is a function of the interest-rate differentials over time.

When businesses employ the use of forward contracts for forex purposes, risk is eliminated from the equation.

Assuming the Brexit negotiations completely fall apart, it is not inconceivable that the value of the GBP/USD pair will plummet.

If a business in the US is relying on a set GBP amount which it expects to translate into an equivalent USD amount, this type of geopolitical shock can undo expectations and result in sharp losses. Fortunately, a forward contract can safeguard expected returns.

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