5 Ways to Manage Forex Volatility During International Payments

International trade is no longer just for big businesses. In today’s hyperconnected marketplace, smaller companies too can take advantage of both the cost savings and growth that cross-border business can deliver.

But doing international business comes with risks, one of which is the potential impact of foreign currency exchange (forex) fluctuations. A forex payment is any cross-border payment that requires a currency conversion between two currencies. The payment is converted from one currency to another using an exchange, bank, or payments platform.

To make the most of international opportunities, businesses should set themselves up for the seamless transfer of foreign currencies, all while staying smart about exchange rates and other potential fees.

Here's a look at why it’s so important to understand forex volatility, followed by five actions that companies can take to better manage their forex payments and protect their businesses from the impact of currency fluctuations.

Why you should consider forex volatility when making international payments

When a company transacts using forex payments – whether buying from a supplier overseas or accepting orders and payments from global customers – currency volatility should be top of mind. Not only do forex payments involve additional fees like transaction and conversion charges, but a sudden unmitigated shift in currency valuations can send costs skyrocketing or profits plummeting. 

For example, consider a U.S.-based apparel manufacturer that places a fabric order from an Indian supplier in July. However, the apparel manufacturer doesn’t actually make payment until the order ships in December. At this point, the value of the Indian rupee has appreciated by 15%, meaning the apparel company is likely to find itself paying 15% more than it would have if it made the payment in July. Conversely, if the rupee had depreciated, the apparel company might see reduced costs or higher profits. Similarly, this forex volatility can also affect income from the apparel company’s international customers – impacting the value of the payments received, sometimes less, sometimes more than anticipated.

Below are five ways companies can manage forex volatility.

1. Encourage early payments

For companies that are exposed to currency volatility simply because they sell to international customers, one of the easiest ways to mitigate forex risk is to establish early payment terms.

Asking for all – or a significant portion – of the payment for a cross-border transaction upfront eliminates any guesswork about how forex rates may change between the time the contract is signed and when the customer makes the payment, which can therefore reduce negative financial impact.  

By investing in the right technology and partnering with efficient forex payment solutions, a company can centralize its AP and AR data, streamline payment processing, eliminate manual errors and missteps, and reduce reliance on high fee spot transactions. 

While this may be the most straightforward solution, some customers may balk at early payment terms. To alleviate or prevent such cases, it can help to incentivize the early payment by offering a discount or a credit towards future purchases.

2. Make use of forward contracts

Another approach to hedge against the risk of forex fluctuations is to use a forward contract. A forward contract enables the parties involved in a transaction to set the exchange rate for the forex payment in advance.

For example, imagine a U.S.-based furniture manufacturer plans to buy $25,000 worth of wood from a Chilean lumber supplier. Typically, the lumber supplier’s payment terms stipulate that the furniture maker should pay for the supplies when they receive them in six months. However, the dollar could strengthen between now and then, meaning the furniture company would end up paying more for the wood than it planned. By using a forward contract, the two companies would lock in the foreign exchange rate at the time of the initial sale, thereby protecting the buyer from negative currency swings. 

There are different types of forward contracts, including:

• Fixed-date forward contracts, which lock in a beneficial exchange rate, in advance, for a payment on a specific date (up to two years in the future).
• Window forward contracts, which lock in a current foreign exchange rate with the option for the forex payments to take place at any point during the specified window (up to two years in the future). These can be a better option for when it’s not clear when the funds will be exchanged or in situations in which there will be multiple forex payments taking place.

While forward contracts can help keep cash flow predictable when buying and selling overseas, there are also situations in which currency fluctuations can turn out to be favorable to your business. With a forward contract, a business could miss out on this. For this reason, some businesses may choose to use a forward contract for only a portion of the total forex payment to minimize the impact of unfavorable shifts in currency valuations, while still remaining open to potential profitable movements in forex rates.

3. Take advantage of a natural hedge

Rather than solely manage currency risks at the individual transaction level, companies can also manage their exposure to currency risks at the business level. To do so, a company can align its cross-border transactions in a way that minimizes their currency exchange risk – a strategy known as a “natural hedge” against forex volatility. A natural hedge is all about balancing the money a company receives in a foreign currency (like international sales revenue) with the money it spends in that same currency (like purchases from international suppliers). The goal is to have these inflows and outflows offset each other, reducing the net effect of currency fluctuations.

For example, consider a U.S. company with annual sales of Mex$1,000,000 in Mexico. To reduce its currency exchange risk, the company could align its expenditures by spending a similar amount in Mexican pesos when purchasing from Mexican suppliers. This approach means that any positive or negative changes in the exchange rate affecting sales revenue would be counterbalanced by corresponding changes in expenditure.

Compared to other forex volatility mitigation methods, natural hedges are usually less flexible because they can take time to coordinate and may not be easily reversed. They can also result in imperfect hedges, in which the forex risk is not perfectly balanced. That said, natural hedges can reduce a company’s reliance on fee-based currency exchanges.

4. Transact in your own currency when possible

Companies doing international business often choose to exchange their currency to that of another company’s for a few reasons: it caters to a customer’s preferences, it can improve supplier relations, and in some cases is even a regulatory requirement. 

But there are also situations in which a business may be unnecessarily exposed to forex volatility. For example, when employees make purchases on international business trips, transacting in the business’s home currency can avoid forex risk. Establishing policies around international purchases and making payment in the company’s home currency can further limit unnecessary exposure to currency volatility.

5. Streamline your payment solutions

In many businesses, forex volatility risk management falls to the CFO or treasurer. But manually managing forex payments can be a challenging task, especially for smaller businesses without a dedicated financial officer. And the more a business increases its international trading, the more difficult it will be to keep up.

To effectively manage forex payments, integrating them into streamlined accounts payable (AP) and accounts receivable (AR) processes, supported by robust financial management tools, is crucial. These tools make it possible to manage and automate forex transactions. They not only reduce the time and effort required for informed decision-making, but also minimize the risks associated with forex operations.

By investing in the right technology and partnering with efficient forex payment solutions, a company can centralize its AP and AR data, streamline payment processing, eliminate manual errors and missteps, and reduce reliance on high fee spot transactions. These tech solutions can also open up opportunities to analyze the company’s forex payment patterns, enabling businesses to identify and capitalize on opportunities to further decrease costs and mitigate risks.

The bottom line

Conducting international business offers a wealth of opportunities to increase sales, expand into new markets, and cut costs. But when international trade involves forex payments, businesses should bear in mind the inherent business risk of currency volatility. Businesses that trade with partners or customers in currencies other than their own can take steps to mitigate the forex risk inherent in these transactions to protect their cash flow and profitability, from encouraging early payments and using natural hedges, to taking advantage of forward contracts and top-shelf financial management technology.

 A version of this article was originally published on September 12, 2019.

Photo: Getty Images