Most businesses deal with foreign currency exchange to some extent. It could be as simple as travel to foreign countries for conferences or as significant as paying millions of dollars to overseas suppliers. In my last post I introduced some terminology, warned about the outrageous foreign exchange rates that banks charge, and recommended you set up a foreign exchange service for your business.
In this post, I’ll give one more transaction cost tip, and then I’ll move on to a practice that can save you much more than a few percent on transaction costs.
Where possible, use foreign currency bank accounts and debit/credit cards
If you frequently travel to or make purchases from a foreign country, I recommend opening a bank account denominated in that currency. This allows you to minimize transaction costs by periodically buying the foreign currency to deposit into that account.
Having a debit card on that account, or a credit card linked to it, allows you to make routine purchases, such as meals while traveling, without paying transaction costs each time.
Using your local debit or card or credit card for foreign currency transactions comes with terrible exchange rates and sometimes additional fees for each transaction.
The bank in your country might offer accounts in different currencies. For example, most Canadian banks offer accounts in both CAD and USD. Some banks also allow foreign citizens to open accounts. For example, Wells Fargo in the US allows Canadian citizens to open accounts.
Rules and conditions vary across banks, currencies, and countries, so this may not be possible in all situations.
Hedging is not just for gamblers and big businesses
Having a foreign currency bank account is an example of a simple hedge.
Hedging is basically a way to protect yourself from changing values of foreign currencies by locking in the current rate for future transactions. While minimizing transaction costs can save you a few percentage points, hedging can save you much more than that.
Foreign currency values fluctuate wildly. The Canadian dollar has lost about 30% of its value against the US dollar in the last year (late 2014 to late 2015).
If you need to purchase $100,000 USD with CAD, it would cost you $30,000 CAD more now compared to a year ago.
Using the bank account example, if you had bought USD with CAD a year ago and kept it in a USD bank account, you would have saved yourself $30,000.
In hindsight that would have been a good idea, but there are two problems. First, you tied up $100,000 for a year. Second, the USD could have declined against the CAD instead of the other way around.
A better way to hedge is to purchase a hedging instrument.
I have been involved in small businesses with cross-border money movement for almost 10 years. I didn’t even consider hedging for the first few years because I thought the costs and complexity wouldn’t be worth the benefits.
However, our foreign exchange service showed me how inexpensive and simple foreign exchange hedging can be. They approved the company for a given credit limit and suggested I hedge about half of my expected needs over the next 90 days. I simply told them how much I wanted to hedge, and they created a contract allowing me to exchange funds at a given rate at any time over the next 90 days (called a forward contract).
The only cost was the exchange rate would be a fraction of a percentage higher than the spot rate. This is a small price to pay given the potentially huge swings in exchange rates.
Over the first few months the Canadian dollar weakened, and the hedge saved us several thousand dollars.
You can save your business bundles by being intentional about foreign exchange through minimizing transaction costs and hedging against future fluctuation.
Question: How have you used hedging to protect your business against foreign exchange fluctuation?