Understanding the ins and outs of exchange rates and trading instruments is critical to mastering your company’s foreign currency strategy.
The world of foreign currency can appear complicated and risky at first. But having a handle on it is easier than you might think, and it’s critical if you want to stay ahead of the competition.
Here’s an insider’s guide on reading currency exchange rates to get you started right now.
Forward Rates vs Spot Rates
The rate at which one country’s currency is exchanged for another is known as an exchange rate.
A forward rate is a contract to exchange two currencies at an agreed rate at a future date, whereas a spot rate is the current exchange rate. This can be at a higher or lower price than the current spot rate.
Assume your company is headquartered in Australia, and you’ve contracted to buy items from a Japanese company for $30 in Japanese yen (JPY) in 30 days.
Variations in the spot rate during the following 30 days could result in the goods costing you substantially more or far less than they would today.
Because you can’t forecast the future, you might consider taking out a forward contract to lock in a AUD to JPY exchange rate in the future. Hedging is the technique of protecting against future fluctuations.
Hedging ensures that future costs are predictable, allowing for better cash flow management.
Spot Market Dealing
You can consider trading foreign currency directly in the spot market as part of your foreign exchange strategy. This could be for a variety of reasons, including covering more immediate international expenses, taking advantage of favourable rates, or building foreign currency reserves.
Whatever the situation may be, there are several tools available to help you reduce the risk involved in this form of trading.
Limit orders are used to buy or sell a specific amount of foreign currency at a set rate. The order will be executed if the currency is trading at this ‘limit.’
A stop loss safeguards the value of your investment by defining a low water mark, or the utmost amount you’re willing to lose on the deal. If the value of your holding falls below this threshold, it is liquidated to prevent further losses.
OCO Order (One Cancels the Other)
An OCO order combines a limit order and a stop loss, with the additional condition that if one of these orders is triggered, the other is cancelled.
An OCO, for example, might be used to create an upper limit order and a lower stop loss for selling your holding. If one is activated, the other is cancelled, allowing your currency to trade freely within the pre-determined range.
So these are the essential phrases and tools to be aware of. The next step is to enlist the services of a knowledgeable foreign exchange partner who can help you make sense of the market and advise you on how to minimize currency risk while maximizing earnings.