International SMEs Need to Become Familiar With Currency Forwards
- 06 Aug 2021
In the financial sense, any good international entrepreneur needs to know about Currency Forwards for SMEs. These are contracts made regarding foreign exchange that can save a business thousands of dollars, as well as the uncertainty that comes with dealing in different currencies.
What are currency forwards and why do international SMEs need to become familiar with them?
A currency forward, otherwise known as a forward contract, is a type of FX hedging that is useful when making regular international money transfers. Put simply, it is a way of fixing the current exchange rate for a currency pair as the rate for future transfers.
With a Forex or FX forward in place, you do not have to worry about a currency getting stronger or weaker and impacting the amount of money your business is earning.
Currency forwards may not seem all that important if your experience dealing with foreign exchange has been limited to certain countries. For the most part, the GBP/EUR pairing does not fluctuate so much that it makes a significant difference to companies not transferring at a major scale.
However, as your business grows, the differences may begin to matter. And if you are doing business in developing countries with more volatile currencies, the changing exchange rate from month to month can wreak havoc on your balance sheets.
If you look at the South African Rand (ZAR) for example, you can see how much certain currencies can swing. Just over the past year, there have been times when you would get 1 GBP for 19 ZAR and times when you would have to shell out more than 23 ZAR! If you are earning in ZAR and bringing your income into a British bank account, you end up with vastly different amounts of local currency for the same amount of income.
There is always reason to use FX forward contracts when dealing with foreign currency as a business. However, that does not mean it is always necessary. If you are largely working in countries that use the euro, US dollar, or Japanese Yen, you're not going to see much volatility. When prices do change, the difference is not major. By looking at how much you expect to earn in a month and comparing how much you would get for it according to various exchange rates from over the past year, you will be able to decide whether the difference matters.
It is when doing business in developing countries or countries with significant economic volatility that currency forwards become very useful. With these currencies, it is almost impossible to predict what the exchange rate will be at future dates. Even if you are aware of all the factors that influence a particular currency, it is often impossible to know which of these factors will come into play.
An unexpected political, economic, or security crisis will play havoc on the currency as people rush to get their money out of the country. There is no way of predicting these events.
There is an argument to be made against the use of forward contracts. While having a forward contract in place will protect you from dips in the currency of the country you're doing business in, you'll lose out if the currency of the country strengthens. Looking at the ZAR/GBP pairing, if you are only getting 1 GBP for 23 ZAR, a swing that over time gets you 1 GBP for just 19 ZAR is going to be significantly useful.
However, this is a somewhat myopic way of looking at the subject. As a business owner, you need to be able to make decisions for your business, and that requires you to know what kind of income you will be receiving on a month-to-month basis. While the currency could swing in your favour, it could do the opposite, and the uncertainty makes it difficult to make those important decisions.
Stability is worth far more than any potential extra earnings you will receive if the currency swings in your favour. For this reason, FX hedging is an important tool for any and every SME doing business in countries with volatile currencies.
It is also important to mention that even though keeping track of all of the factors influencing a volatile currency can be interesting and extremely useful if you are trading Forex, it is a major drain on your time if you are just trying to run a business. You should not have to know the entire economic and political past and present of a country just so that you can be sure of your earnings.
Use currency forwards to save yourself from the uncertainty. You won’t regret always having the right numbers to make sense of your balance sheet.