How companies can limit foreign exchange losses

Personal finance

How companies can limit foreign exchange losses

Foreign currency fluctuations are a common occurrence in business transactions. Fluctuations in exchange rates can be good or bad for the business. Companies that carry out transactions in different currencies are exposed to exchange rate risks.

An example is a Kenyan individual who chooses to buy a certain product from a US company in dollars. Assuming that the Kenyan individual then only has Kenyan shillings with which to buy the goods, he will have to convert his shillings into dollars to make the purchase.

A fluctuation in the exchange rate can work for or against it. If the price is fixed when the contract is made and the shilling loses against the dollar, he will have to pay more to meet the contract price in dollars.

This is a simple example of how exchange rate fluctuations affect international transactions. Much larger companies feel the impact of exchange rate fluctuations more. For example, a business importing goods may feel the negative effect of exchange rate fluctuations as the business may incur massive losses as a result.

It is therefore important for businesses and individuals to learn how to mitigate the risk arising from exchange rate fluctuations. These fluctuations can be favorable or unfavorable to your business. A foreign gain can be beneficial because it can be reported as business income. A foreign exchange loss can have a negative impact on the business.

For about two months, the Kenyan shilling has lost a lot against the dollar. The loss in value is said to be due to a continued shortage of dollars. According to the media, the shortage is artificial in the sense that many investors hold onto their dollars, creating a shortage. The price of imports is therefore higher and consumers feel more of an impact.

One way to mitigate currency risk is to write contracts that contain risk mitigation strategies.

One tip is to trade in your own currency. If it is a purchase transaction, one can hedge against currency risk by transacting in one’s own currency, so a Kenyan buyer would import goods in Kenyan shillings. The seller will thus bear the exchange risk.

In larger transactions, especially those that are long-term in nature, currency risk clauses are written to reduce losses resulting from currency losses. Long-term contracts will certainly be subject to fluctuations in long-term exchange rates. In most commercial contracts, the exchange clause is triggered as soon as the losses reach a certain threshold.

In some contracts, the risk is transferred to one party and the party agrees to bear the risk of currency loss. This is particularly the case in sales transactions where the seller transfers the risk of an international commercial transaction to the customer. This is important to note for Kenyan exporters who export various goods and services to the international market.

A third way to mitigate currency risk is to fix the exchange rate in the contract. While the exchange rate is set by market forces and the regulator with respect to contract performance, the rate can be predetermined.

For example, should the applicable rate be on the date of conclusion of the contract, the date of delivery or the date of payment for the goods? It is necessary to clearly define the applicable rate in order to avoid conflicts of interpretation.

The last option is to allow revision of the contract if fluctuations in exchange rates are of such magnitude that they affect the profitability and performance of the contract.