The values of emerging and frontier market currencies tend to be volatile against major international currencies such as the US dollar or euro. For example, in 2015/16, the South African rand has seen huge fluctuations in its value. Imagine you were a South Africa-based company with a regular monthly expense of $199. In February 2015 that cost would have been R2,318 in local currency terms; but exactly 12 months later it would have been R3,176. On the other hand, if you sold products in US dollars you would have benefitted handsomely from the loss in value of the rand from R11.65/$1 to R15.96/$1 over the period.
The first step in devising a foreign currency-risk mitigation strategy is to determine the areas of your business that are exposed to currency fluctuations. You can then work out a strategy to protect your start-up against these uncertainties.
Account for currency risks in your business model
The simplest step for protecting yourself against negative exchange rate movements is to account for them in your business model. For instance, if your start-up is selling a software package online priced in US dollar, you need to ensure that the project will remain financially viable even if your local currency strengthens sharply against the dollar. Ensure you’ve built in a large enough profit margin to withstand currency fluctuations.
There is also the option of increasing your prices in the face of unfavourable exchange rate movements, but this could make your product or service uncompetitive internationally, leading to a drop in overall sales. Depending on your type of business, you could also consider charging local and international customers different prices, a method often employed in the tourism industry. This will protect your domestic customers from negative currency shifts.
Negotiate a fixed exchange rate with your client
If you are providing a product or service to a foreign client for which you will be paid only at a later date, you can negotiate to fix the price at a certain exchange rate, and then bill the client in your local currency. Many clients will not be open to such a suggestion as it transfers the risk to them, but it is worth asking. If you provide an essential service, they might be willing to do it.
Although such an arrangement will protect you against downside risk, it also means you will miss out on the advantages of a favourable movement in the exchange rate. However, it is best to remain focused on your core business and achieving an acceptable profit margin, rather than try and predict future exchange rates. Don’t torment yourself for having missed a favourable movement in the currency – it could just as easily gone the other way.
Establish suppliers in multiple countries
Take advantage of currency movements by outsourcing work to countries with a beneficial exchange rate at a certain time. For instance, if you are a Kenya-based business that regularly outsources web-development work, you could sub-contract an Indian company when the Kenyan shilling/Indian rupee exchange rate is favourable. And during times when the Kenyan shilling is strong, you can allocate the work to a local Kenyan company.
Open a foreign currency bank account
Many banks now offer accounts in major foreign currencies such as the US dollar, euro or British pound. With these accounts you don’t have to pay a conversion fee each time you receive or pay in foreign currency. In addition, money can be left in the account until an opportune time to convert it to your local currency.
Make use of forward exchange contracts and currency options
Forward exchange contracts and currency options – offered by banks and other financial institutions – allow you to safeguard against unfriendly exchange rate movements.
With a forward contract, you can lock in an exchange rate today for settlement sometime in the future. A currency option, on the other hand, gives companies the right, but not the obligation, to buy or sell a currency at a fixed rate of exchange at a predetermined date in the future. Options are bought for a set price, and are regarded as a form of insurance.
Forward contracts and currency options are relatively sophisticated financial instruments and more suitable for large companies. Taking out these products can be expensive for small businesses and the administration around them time consuming.