01/10/10

By Mike Doyle

The current perceived instability of the currency markets have left some SMEs shaken. Fearful to enter a market perceived as continuously fluctuating and risky, over 50% of SMEs suggest that currency fluctuations seriously influence their abilities to trade overseas and 42% of those that do trade overseas suggest currency fluctuations also effect profitability of the business. It is clear that SMEs feel the burn of currency risk.

However despite these fears, the untapped foreign markets are seen as integral to Britain’s recovery via the export market. Encouraging SMEs to forgo the risks of currency fluctuations is an important step in developing Britain’s export market and doing so requires an explanation about methods to tackle the fluctuations. So what can SMEs do when it comes to trading overseas? One option is to agree an acceptable rate of currency and trade on that currency at an agreed point in the future after the transfer of products or conclusion of the service has been carried out. Or put more simply arrange a “forward contract”.

By definition a foreign exchange forward contract is a way to enable a seller to lock a buyer into a selling price for an asset with the transaction set in the future. It relies on both a buyer and a seller to agree on a fixed price point, this price can be influenced by additional factors depending on what is being traded, and the date of settlement. Whilst this method could be applied to any transaction that might be influenced by fluctuations in the product’s value, currencies have a certain affinity with this method of trading and as such forward contracts are seen as a way of managing the risk of a fluctuating currency.

So why should you care about forward contracts? Apart from the fact that they can avoid the pitfalls of a fluctuating currency market they can also enable you to protect your profit margin. For example, let’s say that you are a UK based small retail business interested in selling apparel to Australian markets. You have a distributor who is interested in your stock however you want to ensure that the trade happens at a favourable rate. By setting the rate of exchange based on today’s rate you can ensure that your profit will remain the same despite the actual date of trade. In the event of a fall in value for GBP vs AUD you can ensure that you retain exactly the same rate as previously agreed upon and thus a locked profit margin. Of course the same occurs for when the value drops — you retain a static rate of exchange and thus have a protected profit margin.

It is clear why you should use a forward contract if you are worried about the effect of a fluctuating currency market on the ability to trade, however one question remains: how do you actually set up a forward currency contract?

In the example above if you were selling your product then you could set up a forward contract with a Forex dealer to sell currency at a set point in the future. This enables you to trade your product at a set price with your foreign client in their currency. Funds from your client would go to your forex dealer who would then honour the forward contract essentially buying the currency from you at a rate that was defined in the forward contract at the date agreed.

Forward contracts are the simplest solution against currency fluctuations and as such offer SMEs the opportunity to trade in foreign markets with a certain sense of ease. To find out more about forward contracts simply visit a corporate foreign exchange specialist like Corporate FX.