Managing FX risk with the provision of credit

This is less a study of how to solve the FX market, but instead, how effectively managing the FX market might have wider implications for your business and how we work with you to solve them.

Our client imports finished products from Europe, the US and Israel. As all their product cost base is in foreign currency, they are particularly sensitive to market moves and these moves risk impacting their profit margin.

They want to protect their margins by using forward contracts but, as a high growth business, are concerned about how their cashflow might be impacted by having to place initial margin and variation margin to support these contracts.

Hamilton Court advocate for businesses to identify and manage risks across their business, even though we can only directly help them manage their foreign exchange risks!

Our client has order lead times of eight to sixteen weeks and payment terms that range from pro-forma to 60-days after receipt. This means that that they have a requirement to pay their invoices between one and 180 days from placing their order.

As they have specific invoices and therefore known costs, we’ suggested they enter a forward contract on a ‘per invoice’ basis, meaning taking out a contract to lock in the exchange rate. So what does this mean for them?

This means they know their exact cost in pounds for each invoice they receive, which means as long as they sell their goods at the price they expect, their margin is protected.

When the invoice is due, the forward contract matures. Our client then sends us the Pounds and we pay their supplier directly, in foreign currency.

Usually when you book a forward contract, you pay a deposit of between three and ten percent of the total value of the contract. So Why do we ask for a deposit?

Every contract that we enter into with a client, we take an equal and opposite position with one of our counterparties. We take the deposit so that if for any reason you are unable to settle the contract, we are able to close it and settle any loss that occurs.

This is known as placing initial margin and the money deposited will be used towards the final balance payable when the contract settles.

If there are material market moves and the forward contract moves ‘out of the money’ then we might request a top up of the margin, because if you were unable, or decided not to settle, the loss on closing the contract with our counterparty might be more than the money you have placed with us.

This is known as variation margin and will also be used towards the final balance payable.

To eliminate the need for initial margin and reduce the likelihood of calling for variation margin, we have given the client a credit facility. This means they don’t pay any initial margin when they take out a contract and would only pay variation margin if the market moves considerably.

Before we offered the credit line, we did our due diligence with a credit check and reviewed their latest financial statements.

Once we were happy with the risk, it was a case of the client signing our credit agreement and getting going.

Having the bulk of your costs in foreign currency gives a greater degree of sensitivity to the FX market than businesses where only a couple of components are sourced in countries and currencies different to your own.

Getting a handle on this risk is important, but making sure that this solution doesn’t have any unintended consequences – such as tying up valuable working capital – is a must.

By offering a credit facility to our client we’ve achieved both. They have no risk of the markets moving adversely and a greatly reduced risk of tying up working capital in achieving this.