The forex market is volatile and comes with a lot of risks, especially for business owners & short term traders.
Global volatility is on the rise due to socio-economic factors such as the Russia vs Ukraine conflict and the lockdowns in China due to the Covid omicron variant. Lately, the Bank of England & other Central banks have increased their interest rates due to the soaring inflation.
CBOE Volatility Index (VIX), which is used as a measure of the amount of fear and risk in the market for the next 30 days has crossed the safe 20 point mark and now sits at 30.02. This means that there could be higher currency pair fluctuations within the forecast period (30 days).
We would be discussing some approaches to reduce your risk when trading short term.
How does exchange rate volatility affect businesses?
Exchange rate is the price at which you can purchase a currency with another currency. For example, if USD/GBP exchange rate is 0.82 it will require 0.82 GBP (quote currency) to buy 1 USD (base currency). Thus, exchange rate volatility has a great effect on your business.
The movement of currency prices can be beneficial or detrimental based on the forex market fluctuations. The exchange rate volatility can affect your business directly or indirectly.
- Direct Impact: This could apply to a business involved in foreign trade. As an importer or exporter, you would have to pay/gain more or less depending on the exchange rate while running transactions. Depreciation of the home currency makes imports more costly and exports cheaper.
- Indirect Impact: Exchange Rate affects the operational costs of running a business. For example, you need fuel to run your business effectively. If fuel prices go up due to exchange rate fluctuations, this would translate to a higher operating cost for your business.
How to Hedge Exchange Rate Risks
Due to high short-term forex market volatility, it is imperative in some cases to minimize risks. This can be achieved using the following:
Contract for Difference (CFD)
A Contract for Difference (CFD) is an agreement between two parties whereby the buyer makes a profit/loss by predicting the rise or fall in the price of the asset without actually owning the underlying asset.
You buy CFDs or go long if you foresee a rise in the price of the asset. You sell CFDs if you predict a fall in the price of the asset.
The other party (your broker or the market participants) automatically takes the opposite side of your position. If you go long, your broker will go short and vice versa.
You make a profit only if your prediction comes true. You have to pay your broker the difference between the entry price and exit price in the event of a loss. CFDs are not traded on any exchange, it’s simply a contract between a buyer and a broker.
Example a dish manufacturer in the UK exports dishes to the USA and is expecting payment in USD currency in 2 weeks. He then hears news of rising inflation in the US and fears it might weaken the USD. A weaker USD means translation risk because when he converts the money back to GBP it would be less.
He could approach any regulated CFD broker based in the UK and take a short position on USD/GBP. If the manufacturer is right and the USD weakens then the USD/GBP exchange rate would fall and the manufacturer gets paid the price difference. He can use this profit from CFDs to offset any loss recorded from supplying dishes to the USA. In this case, he would have successfully managed the short term forex market volatility risk.
However going short on currency CFDs comes with its own risk because of high volatility in today’s markets going short means the exchange rate can suddenly gap upwards without any trading in between especially when you keep a position open over the weekend. Those using CFDs to hedge risk should use guaranteed stop loss orders because the markets are very volatile presently he warned.
Using a Guaranteed Stop Loss Order (GSLO) helps manage risk when volatility is high because it assures that your open order will be closed once the exchange rate crosses a predetermined stop price.
If the dish manufacturer in the previous example uses a GSLO, his CFD position will be closed and his USD/GBP sold off at the next available price when the USD/GBP rate rises past the stop price he has set. This will help him cut his losses. It is important to note that CFD trading is very risky due to the high leverage associated with it.
Futures Contract, also known as futures, is an agreement between two parties to buy or sell a predetermined quantity of an underlying asset, at a predetermined price, and at a predetermined future date.
Futures contracts are exchange traded and available on the London Stock Exchange (LSE). However, the LSE has stopped trading interest rate derivatives on its Curve Global Markets platform due to un-profitability. Equity Index Futures and Fixed Income futures are available to the public on the LSE
Example when a holder of a futures contract makes a commitment to buy a commodity or asset at an agreed price in the future, upon contract expiry the contract seller will physically deliver the asset or commodity to the holder or settle the price difference in cash without any need for physical delivery.
Futures contracts are marked to market daily with gains and losses reflecting in the contract holder’s account.
For example, Mr. A in the UK wants to sell Gold to Mr. B in the US. He decides to go into a futures contract with Mr. B because of the high volatility of the Pound Sterling against the Dollar. They both agree on £220 per kilogram of Gold at a future date.
If the price of Gold falls to £210 the next day, the futures contract holder has made a profit of £10 per kilo since he entered into the contract at a higher price.
The contract seller has lost £10 per kilo because he would have bought the gold at a lesser price if he wasn’t in that contract.
Trading futures is risky as the market price changes of the assets can be against you. Forward contracts are similar to futures but they are not traded on the exchange and have a higher default rate. However they are not marked to market like futures contract and are used mainly by farmers to lock in prices of soft commodities.
Options contract is an exchange traded agreement that gives the holder the right, but not the obligation, to buy or sell an underlying asset at a given price (strike price) on or before a specified date.
Options Contracts are quite different from futures because the buyer isn’t mandated to exercise action at the end of the contract. Also, the contract can be exercised on or before the agreed date (American styled options). In the UK however, options contracts can only be exercised on the expiration date (European styled options).
Options offer a form of leverage by giving the buyer the right to predict the rise or fall of the security without actually owning the asset. The option holder compensates the option writer or seller with a fee called a premium. Options contracts are of two types, ‘Call’ and ‘Put’.
Firstly, a call option gives the right, but not the obligation, to the holder to purchase the underlying asset from the option writer at the specified strike price irrespective of the current market price of the asset after predicting a price increase.
Secondly, a put option grants the holder the right to sell the underlying asset to the option writer at the strike price irrespective of the current market price after making a bet that the prices would fall.
The option holder isn’t mandated to exercise the option. If the holder decides to exercise his right, the option writer must fulfill his contractual obligations.
Example a baker in the UK who imports wheat from USA plans to import 10,000 Bushels at the rate of $5 per bushel in one month’s time. However he has to convert his GBP to USD at an exchange rate of $0.82. This means the total cost is 10,000 bushels x $5 x $0.82 = 41,000 pounds
He turns on the TV and hears that the US Fed reserve Bank plans additional interest rate hikes. He knows that a hike in interest rates will make the USD stronger and USD/GBP exchange rate will rise. This means it will require more GBP to buy 1 USD.
If the USD/GBP exchange rate strengthens from 0.82 to say 0.86 it means the new total cost of importing wheat will be 10,000 bushels x $5 x $0.86 = 43,000 pounds
To avoid paying higher he runs to his broker and buys a Maize call option contract at a premium of say 10 pounds that gives him the right but not the obligation to buy 10,000 bushels of maize at 41,000 pounds, one month from now.
If the US Dollar does not strengthen and the exchange rate stays at $0.82 the baker who is the option holder forfeits the premium paid to the option writer. By using a call option he has managed the risk of exchange rate changes and the premium forgone is the price he pays for certainty and peace of mind.
The concept is the same for a put option which is used when you think exchange rates will fall.
Despite the forex market volatility, business owners can mitigate some risks. You should analyze the forex market carefully before setting the price of an asset.