We are sure that you’re aware that the new pound coin came into circulation on Tuesday 28th March and from October 2017, the current £1 will cease to be legal tender. Of course, the new coin will have the same value as the old coin, I mean a pound is still a pound, but this leads us into thinking, what do you do when buying from abroad as the pound is fluctuating in value?
Here’s an example.
Suppose I need to go out and buy some nice new piggy banks to put all these new pound coins in. I write a specification, get 3 quotes and choose the one that satisfies my MEAT. The supplier is in France and is quoting me in euros, at a price of €1.15 per piggy. At today’s exchange rate of £1 = €1.15, each piggy will cost me £1. I send off an order for 1,000 a month for the next 12 months at a price of €1,150 to be paid monthly on receipt of goods. This gives me an overall price of €13,800 for the year. I set aside £12,000 to pay for this.
At first all goes well, but then the exchange rate starts to move. By month three, the pound has fallen so instead of getting €1.15 for my pound, it will now only buy me €1.05. The supplier has sent me his standard monthly bill for €1,150 but now I must spend £1,095 instead of £1,000 to pay this amount of euros. I’ve just lost £95 and it’s only month three!
How could I have stopped this happening?
Well, when you look at it, by agreeing to pay in euros I have taken all the risk of exchange rate movements. Yes, if the pound had strengthened I would have made money, but it’s impossible to predict the future. There is no such thing as an accurate crystal ball!
Instead, I could have asked my supplier if I could pay in pounds. In this case, the supplier would take all of the risk and I would always pay £12,000 for the year’s supply, whatever the exchange rate. Of course, the supplier might not agree!
Or, another option would be to ask the supplier to share the risk and to split the difference. At the end of each month, we would tot up the effect of any change in exchange rate and adjust the price to reflect an equal share in the gain or loss due to this.
Another approach would be for me to protect myself against the risk, by a process often known as “hedging”. Essentially, I go to my bank and buy Euros now at the current rate. I exchange £12,000 into the €13,800 needed for the year’s supply of piggy banks. But, what if I don’t have £12,000 in my bank? Well, I can enter into what is known as a “futures contract” with my bank. This means that I can exchange my pounds into euros on specific monthly dates in the future, at a price that is fixed when I enter the contract. I will have to pay a small premium for this however, as in this case, the bank is taking the risk. With this option, at least I know exactly what I am going to pay over the year and am not exposed to the vagaries of the exchange rate.
Don’t try to foretell the future! People have been using crystal balls and tea leaves to do this for a long time, and they don’t work!
Don’t bet on which way the exchange rate will move.
If you can’t afford to lose, protect yourself by shifting the risk elsewhere.