Being in export business (cross border) means involved in dealing with two different countries & currencies. Production will take place in Sri Lanka Rupees (LKR) and sales proceeds will receive in United States Dollar (USD) or any other designated currency. The risk associated with foreign trade is the uncertainty of future exchange rates. The relative values of the two currencies could change between the times the deal and the time payment is received. As mentioned, the value may change in foreign currency meanwhile the business transaction is still taking place. At the time of converting USD into home currency, potential changes in the currency exchange rate affect the business profits, positively or negatively.
Once goods are shipped to another country, there must be certain period goods will travel via sea or air. Even after receipt of goods, as per agreement payment term, the exporter will remit the cash in designated currency. The risk originated when the time converting remittance of USD into LKR, could result in a profit or loss according to the currency fluctuation.
Risk involved in foreign currency fluctuation known as currency risk, Foreign exchange (FX) risk or exchange rate risk.
Foreign currency fluctuation is associated with many other factors such as economic exposure and translation exposure. The economy of the country affecting the exchange market and currency volatility. Translation exposure impact on foreign exchange rates changes.
How Foreign Exchange Risk Works – Example
Sri Lanka (SL) tea exporter sells to a United States (US) retailer 10 containers of tea. 6000 USD per container and total is 60,000 USD. As per sales agreement, The US Company agrees to pay after 1 month of goods received (known as deferred payment term). The shipment time span is 1 month.
Upon confirmation of sales invoice, SL Company takes one month to prepare the delivery of tea and the company spends cash in LKR value up to 8,900,000. By that time 1 USD is equal to LKR 178. Meanwhile, within the period of two months, Sri Lanka facing political turmoil, which led to an economic crisis. USD has been strengthening since LKR weaken. When the SL Company receives remittance after two months’ time as per contract, 1 USD is equal to LKR 182. SL Company made a profit of LKR 4 for USD amount totalling USD 60,000. In other words, LKR 240,000 exchange rate income for Sri Lankan exporter. Nevertheless, exporters are not interested in speculating on foreign exchange fluctuations and prefer to avoid risks.
Impacts of Exchange Rate Risks to Exporter
It’s obvious importance to Sri Lankan exporter to understanding and managing exchange rate risk. Below are the reasons for the same:
- Today’s competitive global business environment has a substantial influence on currency volatility and changes in exchange rates to a greater scale. Same indicates in the company’s bottom line of profitability.
- Foreign exchange volatility may be unprotected to transaction exposure, Translation exposure, and Economic exposure. Exporter gets into the feet of Transaction exposure for when exporter obligations to make or receive payments denominated in foreign currency due to volatility. Translation exposure also due to foreign currency volatility in financial statements when exporter invests in foreign subsidiaries. Translation exposure identified as accounting exposure. Both transaction exposure and Translation exposure are short and medium-term impacts. Economic conditions of a country affect the exchange rate of the currency. Economic exposure takes place when foreign currency volatility affects the exports of future cash flows and market value in the long-term.
- Unanticipated currency changes carriers’ substantial impact on the company’s on-going business concepts. Example garments exporters closing some of the production units since GBP strengthen against LKR cause loss in sales. In another way, if exchange increased that will be a competitive advantage for garments exporters. Exchange risk adversely impacts the operations of an exporter.
- Degree of risk that Exporter exposed when shifts in exchange rates affect the value of assets of business thereby impacting the profitability.
- Depends on the exchange rate, the exporter will budgets and forecasts on certain assumptions. Changes in the exchange rate may cause management to focus on accurate estimation and to engage in hedging tools, which may cost additional chargers.
- The exchange rate is difficult to quantify precisely when exporter deals with multiple countries.
- Exchange rate ultimately affects exporters’ rate of return. Exporter makes more profits when a currency falls in value in relation to other country currencies. At present LKR is depreciate in value while USD is appreciating in value. Therefore more profits to the exporter in the liberalized economy of Sri Lanka. However recent activities are Green signals to SL exporters to participate in exports drive.
- Gain or loss arising when converting the currencies may affect the future cash flows of the firm. The exporter should have exporters in the board to advice exchange rate related Treasury management functions.
To be Continued…
Chapter 2 will Deal with How to Mitigate Exchange Rate Risk
Author Mr LesoKumar, Being banker by profession, he personally believes the partnership with right business banking is significance for the exporters to succeed in the trade. If you are an exporter, who intended to mitigate the risk associated with the exchange rate, please feel free to contact him through digital platforms for any advice in this regard.
Linkedin – Lesokumar SureshKumar