While the pandemic has thrown our economy in turmoil, it is an even bigger worry for people dealing with export and import. The first concern is the international transport and cargo are being operated sporadically, disrupting the global supply chain. With the new coronavirus strain looming over us, you never know when a country will be compelled to shut down its borders again.
And the second concern is the see-sawing condition of the currency exchange. International trading and currency exchange are already risky, to begin with; inflation, a country’s monetary policy, geopolitics- any one of these factors can tip the fragile balance of the currency exchange market. And if you throw the pandemic into the equation, the risk increases tenfold. And many international sellers, buyers, and Forex traders are frantically looking for a way out of this situation. If you are one of them, read on to know how to avoid currency exchange risk in this pandemic.
What Is The Currency Exchange?
To put it simply, it is converting one currency into another; but after conversion, the value doesn’t always add up. When companies buy goods from foreign countries, they have to buy them in the local currency of that country; and this leads to big currency exchange. And when the exchange scale is large, it impacts the exchange rate.
Currencies are exchanged according to a certain rate. If you consider basic economics, the price always increases with the demand. If all companies suddenly want to convert the Canadian dollar with the US dollar, the price of the US dollar will certainly rise against the Canadian dollar. And this will impact the exchange rate.
And when trillions of dollars are being exchanged every day, it certainly causes a fluctuation in currency rate- which changes every second the global transaction takes place.
What Is Forex Trading?
To avoid currency exchange risk you have to Learn How To Trade Forex. When you travel to foreign countries, you exchange your native currency with that country’s currency; and that is an example of currency exchange or Forex Trading. Let’s say, you are going on a holiday from Europe to the USA with 500 euros and by converting it into dollars at an exchange rate of $1.4 per euro, you get $700.
And you decide to hold that amount instead of spending it. Then you move back to Europe and decide to convert that $700 into euro. In the meantime, the exchange rate for the dollar and euro moved from 1.4 to 1.3. That shows, instead of getting your initial €500, now you get €538.5.
The €38.5 extra that you get, is due to the price increase of the dollar. And this concept of holding on to currencies, to exchange them at a higher price is known as Forex trading.
How Does The Exchange Rate Affect The International Trader?
As you might have guessed, this oscillating price of the currency has both upside and downsides to international and Forex traders. For instance, if you decide to buy a certain product from a seller in Germany for €5000, you expect to pay $8400 in Canadian with an exchange rate of $1.68 CAD for one euro.
However, if the value of the euro soars during this time, from $1.68 to $1.78 Canadian, you have to pay $8,900 Canadian. And if you multiply this loss for hundreds of those products you will face extra payment.
On the flip side, if the euro price drops, you might have to pay less for that product. And that presents the dilemma of whether to take some preventive measures for this price fluctuation. But if you want to do that, you might be losing the opportunity to take advantage of a price fluctuation. And this works for both, the sellers and the buyers.
How to Manage Currency Exchange Risk?
As you have some potential gain from currency exchange, it might be tempting to do nothing about the exchange rate fluctuation and to let it run its course. However, in case of a massive fluctuation, you have to face the bitter consequences. Leaving it to fate is nothing short of gambling with your business.
To make sure your business is thriving and in competition, you need to manage some hedging strategy against it. There are two strategies that you can follow-
Forward Exchange Contract
A forward exchange contract allows you to lock in an exchange rate for a transaction that will take place in the future. It might be the simplest way to hedge yourself against the exchange rate volatility.
The concept is to save you from a profit loss, even if it means you have to forgo some opportunity if the market turns in your favor. Weighing all the options, a forward exchange contract might look like a defensive move, but when you consider the scale of your exchange rate, you have no other way to go about it.
How Does Forward Contract Work?
Let’s say, you want to sell $100000 and buy Canadian dollars in three months. But you don’t know how the currency exchange market will turn out for the US or Canadian dollar after three months. To shield you against this uncertainty, you may decide to adopt a forward contract approach.
Based on the current exchange rate you can fix a rate (1.3 us dollar) that will remain valid for the next three months, regardless of the market condition. Now you can rest assured, that when the contract ends you will get $130000, no matter which way the market moves.
FX Options
FX options work similarly to insurance. FX options provide the contractual right to buy or sell currencies at a certain exchange rate on a future date. However, to achieve this right the contract holder has to pay a certain fee or premium. And the contract holder is not obligated to buy or sell that currency. The price of the insurance depends on the chance of exercising the right.
This is similar to an insurance price increase when you are insuring something prone to damage. There are also some variations of FX options where you are not required to pay an initial premium.
While in a forward contract you can't take advantage of the favorable market situation because of the binding nature of the contract, with FX options, you are free to exercise your right even in a convenient market trend.
The Bottom Line
International trading has provided us the opportunity to enjoy the best products from all over the world. You might hardly find anything in your house that is not imported from some other country. But it also has its nuisance, especially with currency exchange. To save your business from potential downfall, you should adopt a convenient hedging strategy that suits your business. Consult with some financial experts to get some insight on how you can adopt a forward contract, FX options, or even a combination of both.
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