Many small businesses buy or sell products or services in a foreign currency and in doing so put their profitability at risk.

Consider this situation – you order products from a factory in China the price of which has been set at US$10,000. The lead time between order and delivery is 120 days (let’s assume that your credit is good enough to get terms of payment on delivery rather than shipment).

At the date of ordering the products the exchange rate is 1.7; when you finally pay, the rate has deteriorated to 1.55 (Scotland, Wales and The People’s Republic of Yorkshire have all voted for independence!). If you do the numbers you will see that, all other things being equal, you will pay £570 more for the product than you had planned, which represents close on a 10% increase in price. If you are buying and selling products, your normal gross margin may be 30% or less, in which case you have just shaved nearly a third off it. I used to work in the metal stockholding industry where our average margin rarely got up to 25%, so a price increase of this magnitude would have been disastrous.

Now of course the rates could have gone the other way, in which case you would make additional profit. But tell me, would you be happy to be at risk from the currency markets (and the politicians!) in this way?

So how do you avoid this situation?

It actually isn’t that difficult; you use a technique called hedging.

A little note: hedging (in this instance) means buying currency against a known future need. It doesn’t mean buying currency because you think the rate is going to move to your advantage. That’s speculation.

In essence you contract to buy the currency when you commit to the order, and it will be delivered when you have to pay; the rate you achieve is likely to be slightly lower than the spot rate at the time – the difference being represented by the bank or brokers margin and the premium or discount at which that currency is compared with sterling (but don’t worry about the mechanics of that at the moment – it’s not in your control!)

There are various flavours of contracts – limit orders, forward limit orders, stop loss orders and options for example – but these are unlikely to be relevant unless you are engaged in significant foreign currency transactions. You can buy forward exchange contracts from your clearing bank or from a broker (the brokers claim that they give better rates but you would need to compare quotes to be sure).

And the same principles apply if you’re selling in a foreign currency – you sell the currency forward. At the moment you will probably build in additional margin to your price to cope with the uncertainty of the exchange rate, and might therefore make your price uncompetitive; with this certainty you will be able to strike the best price without worrying about the currency markets.

If you would like to talk about this issue, please do not hesitate to contact Viewpoint by emailing [email protected].