What are foreign exchange markets and how do they work?
There is no central market where currencies can be traded, such as the London Stock Exchange or the NASDAQ for shares, but, instead, a decentralised market accessed by national central banks - like the Bank of England or the Federal Reserve in the US - or multi-national institutions which engage with buying or selling currencies on behalf of their clients.
The price at which these currency trades take place is known as the interbank rate, and it changes at an exceptionally rapid pace to meet the conditions of the market. Only central banks, multi-national banks and a few select others can access these rates.
Companies like Times Currency Services use this primary network of multi-national banks to buy and sell currencies around the world, effectively creating a secondary foreign exchange market where, instead of big banks trading millions of dollars, smaller businesses and individuals trade smaller quantities of money.
In order for companies like The Times Currency Services to offer this service to smaller businesses and individuals, a slightly different exchange rate is offered. The difference between this rate and the interbank rate is known as the spread and dictates how much money companies like Times Currency Services retain from each trade.
Why have exchange rates been changing?
The majority of developed world currencies are free-floating, meaning the value of that country’s currency can rise and fall against others as the markets see fit. Of the world’s ten most traded currencies, nine are free-floating.
Currencies can also be managed, or ‘pegged’, to other assets including precious metals or even another country’s currency.
Broadly speaking, free-floating exchange rates follow the laws of supply and demand. If a shift takes place that affects either the demand for or the supply of a currency, the price of that currency will shift also. These shifts can be the result of economic, political or central bank policy changes, or something wholly separate to the economic and financial system.
How foreign exchange markets can impact your business
Businesses interact with markets overseas in a number of different ways, be it importing machinery from Europe or exporting goods to China. In many circumstances, this will involve either receiving or sending a foreign currency from or to your business partners and so, naturally, you’ll have exchange rate exposure.
When paying a supplier abroad, it’s this exchange rate exposure that can make a difference to your business. If, for example, you’re contracted to pay an American supplier for a shipment of goods in six months’ time at the cost of $500,000, every per cent of change in the GBPUSD rate will have a direct impact on your bottom line.
At the time of writing, the GBPUSD exchange rate is around 1.27, making your final bill just shy of £394,000 if paid today. However, should the value of the pound fall by 3.5%, GBPUSD would fall to 1.2256, lifting your supplier payment to nearly £408,000 – meaning you’re paying an additional £14,000 for the same shipment of goods. Should exchange rates move in your favour (the pound strengthening in this example), then you’d end up forking out less for your euro payment.
While supplier payments and exporting are some of the more upfront ways in which exchange rates can affect you and your business, there are many other ways currency volatility can trickle into your business including transactional, translational, credit and liquidity exposures:
How your business could be exposed to currency risk
It’s not the nature of these risks themselves, but how you deal with them that will make a difference to your business.
How to move your money overseas
Transferring money can be simple – spot contracts and short-term forwards can be a quick, easy and efficient way of moving your funds from one currency to another. However, this may introduce an element of risk to your business as there’s effectively no way of predicting what the exchange rate will be on your future transfers. So how can you know what your profit margins will be in one week, month or even a years’ time?
For some businesses, using hedging strategies or longer-term forwards can trim some of this risk, and more complex payment solutions can be more suited. At the end of the day, it all comes down to you, your business and the way you approach foreign exchange.
Here is a brief explanation of the ways you can use to move money across borders:
A spot transaction is arguably the simplest way to transfer. You can inquire at any currency specialist to receive a rate quote (this will usually be the interbank rate with a spread applied), and once this is booked, you send the broker the funds for the trade, which are then sent on in your chosen currency.
Fixed term forwards
The most common use of a forward contract is with a fixed-term. These contracts give you a set period over which the exchange rate you receive will be guaranteed at the end of the contract. This period could be as short as five days or as long as three years.
If you want to secure a rate but aren’t yet ready to make the transfer, you can choose a forward contract to fix a rate today for a specified time in the future. The great thing about a forward contract is that you know now exactly how much you’ll get when you’re ready to transfer. It helps you plan and protects you, should rates move against you later. However, a forward contract could work against you if rates move in your favour after you have secured a rate. We strongly recommend that you talk through your options with one of our knowledgeable dealers before choosing what’s best for you.
If you decide that a forward contract is the best choice for you, we’ll ask you to pay an initial deposit so that we can ‘hold’ this rate for you. The size of the deposit will depend on the currency you want, the amount, and when you want it. That deposit will then be used towards the balance when you settle the contract. Failure to settle the contract may result in the loss of your deposit, which is why, when choosing a forward contract, you must be certain that you need the full amount of the currency being purchased. On occasions, we may also ask you to top-up your initial deposit if the exchange rate moved significantly after you’ve guaranteed your rate. This adjustment is called a margin call and will be explained to you in detail by your account manager.
A flexi-forward contract acts similarly to a fixed-term forward; however, you will have the ability to use your forward exchange rate at any point over the lifetime of the contract. This facility can be used numerous times until your nominal trade size (agreed at the beginning of the contract) has been exhausted.