Currency Risk in Business

Fred Wilson on has a nice blog post explaining currency risk in business that is worth a read. For those involved in the US business, currency fluctuations plays little role in day to day business (i.e. sales) so this notion of impact of currency fluctuations is at first a little difficult to understand. But gaining an understanding of the impact of currency fluctuations on your bottom line is critical in International business.

As FW's post says, even if nothing real changes in your business, the change in exchange rate over which you agree to convert the local sales into US dollars can have a significant impact on your profits. So, as it happend last year with the Latin currencies (which experienced significant depreciation over the year), while you might be "making your numbers" in local currency in fact in US dollars you may have under performed - simply because the local currency is not worth as much in US dollars any more.

One can only imagine the demotivating effect this would have on people working in markets where currency is depreciating rapidly - one month you are a top performer for delivering the results, the next month you are not even making your numbers!  Even though you are still selling the same number of widgets the sales are not worth as much in US dollars.

For example - you can see from the two year Indian Rupee/USD currency exchange rate chart below - the havoc this degree of fluctuation must have played in US companies doing a lot of business with India. Let's say you are a US company selling a $1 widget in India for Rs. 50 per widget.

Based on the chart above, in US dollars you made $1 only in December 2009. Before December, you earned 84 cents per widget as the exchange rate at that time was Rs. 42 to a dollar. On the other hand in March you made little more (3 cents to be precise) than $1 per widget because the exchange rate had climbed to Rs 51.6. Since that time the rate has come down steadily to below Rs.45 last April costing company money in USD.

This can't be motivating to sales people in India - they may be underperforming in US dollar terms even though their sales in local currency are just fine.

The way companies manage this exchange rate fluctuations internally is to adopt a certain "budget exchange rate" which is used to calculate the current performance. In this instance, the company may decide that they will convert Indian Rupee sales in to US dollars at a standard rate of Rs. 45 for the entire year to be adjusted up or down for the next year depending on the prevailing market circumstances. This would then take away the uncertainty associated with exchange rate fluctuations.

Of course all this does it help you manage the internal expectations. But it does little to help you protect your bottom line.  For instance, if you report your earnings in US dollars, the real impact on your bottom line is still there, to be found reported in the annual report in the form of favorable or unfavorable currency impact.  In today's interconnected global economy this is unavoidable. However finance gurus do have hedging strategies they can use to minimize the currency impact.
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