As the exporter will have already manufactured and shipped the goods, they will be exposed to any fluctuation in the exchange rate between the time of invoice and the time of payment unless previously negotiated.
Say the invoice were for the equivalent of £10k, he would have invoiced for $13.3k, but when he received the dollars and sold them at 1.4200 he would only have received £9.36k, a loss of £640 or 6.75%.
This used to be considered a cost of doing business but businesses have now become more sophisticated in their management of risk.
There are two ways to mitigate this cost. The first is a little crude and not particularly effective. It is simply to increase the cost to the customer by a percentage amount to offset any exchange rate difference. This could make the product uncompetitive and probably lead to a loss of business.
A more equitable method is to sell to or buy from a payments platform such as CurrencyTransfer.com at the time of invoice for delivery on the due date under the agreed payment terms with your customer/supplier. In this manner the foreign exchange risk is mitigated.
If you buy a currency today and place it on deposit, the interest rate you earn would be higher (or lower) than the currency you sold.
If you had done nothing, you would earn interest on your deposit in the original currency. However, by exchanging for another currency, you will earn more (or less).
To negate this opportunity to make a “risk free profit”, the rate for delivery today differs from the rate for future delivery, by the interest rates applicable
The difference is normally expressed in points, so it is 82 points. If the dollar interest rate were lower than the Sterling interest rate, then the rate for delivery in 90 days would be lower as the points would be deducted.
Banks have never really wanted to clarify FX forward pricing, often building in various risk adjustments and spreads, but when broken down it is a relatively simple calculation.
The risk inherent in a forward FX transaction is not market risk, it is delivery risk and that is why an FX partner will want to take a margin at the time the deal is booked.
About Alan Hill
Alan has been involved in the FX market for more than 25 years and brings a wealth of experience to his content. His knowledge has been gained while trading through some of the most volatile periods of recent history. His commentary relies on an understanding of past events and how they will affect future market performance.”