VentureHow.com’s Managing Currency Risk for Small Business is an overview for entrepreneurs with tips, strategies, and advice.

If you own a small business and deal with foreign currency, you need to consider foreign exchange risk management critically. The risks vary based on several factors, but every company that engages with international markets for its sales, as part of its supply chain or in any other capacity has some degree of risk. Here’s a look at the foreign exchange risks and currency fluctuations and some ideas on managing them.

Managing Currency Risk for Small Business

Foreign exchange risk encompasses a few distinct areas. In many cases, it is the risk of accepting a foreign currency and having it fall in value before you exchange it for your local currency. Some businesses, mitigate this risk by invoicing all of their clients in local currencies or, for example, by having their customers pay in American dollars, regardless of whether or not they are using a foreign bank account. While this methodology covers a great deal of the risk associated with these transactions, it fails to address the risk involved in future operations, and in many cases, a critical portion of a business’s value lies in its future transactions or in its ability to continue to collect revenue or buy supplies.

Because of this, businesses also have to address the risk that if the exchange rate falls, competitors with cheaper products may swoop into the market, reducing their sales. Although the business’s cash flows are denominated in the business’s local currency, they are determined by the value of the foreign currency in relation to the local currency.

To illustrate, imagine a U.S.-based business sells widgets to customers in Japan, but it collects all of its payments in U.S. dollars. This currency strategy helps to protect the business’s immediate foreign exchange risk, but it doesn’t address the long-term risk of the yen falling. If the yen falls, the company typically must lower prices or risk being undercut by competitors — both options strain the business’s cash flows.

To mitigate these risks, small business owners need to assess the exchange risks faced by their businesses, and they need to evaluate the methods available to reduce their risks. Ultimately, business owners need to implement small business foreign currency management techniques including shifting operating practices or exploring forwards, futures, options, and similar strategies.

To underscore the importance of managing currency risk for small businesses, business owners have to look at the recent Brexit debacle. Between the time the markets closed after the vote to leave the European Union and reopened the next morning, the pound fell a stunning 10%. That decrease was felt immediately by any company that does business with the United Kingdom, and according to Keith Underwood, the founder and CEO of Underwood FX Consulting LLC in New York, “[Businesses] will also suffer, as wider spreads due to a larger risk premium in the market will make hedging and trading costlier. They will choose to forego hedging in the face of increased volatility (costs) thereby increasing their risks. The fallout is that doing business in British pounds will become costlier. Period.”

Foreign Exchange Risk Management

To reduce their risks, especially in the face of a Brexit-type event, businesses should first look at their operating procedures. Whenever possible, they should improve risk by diversifying their markets. Theoretically, by working with multiple foreign exchange rates, businesses tend to experience a more consistent average rate as increases in the value of

one currency offset decreases in another. Businesses should also look for ways to embrace production and sales flexibility. If foreign exchange rates fall in a country where a company buys parts which are critical to its manufacturing process, the business, ideally, should have another supply source.

Building flexibility into pricing structures, input and output markets, and sales and production volumes can help businesses with their foreign exchange risk management. However, in addition to reworking their processes, companies also need to consider financial tools to help mitigate risk carefully.

Futures to Reduce FX Risk

Business owners often think that futures or forward exchange contracts are too confusing to deal with on their own, but once they understand the process, many business owners find these contracts relatively simple to navigate. Essentially, futures secure the ability to lock in specific exchange rates.

Futures Option to Subdue Risk

In cases, where a business has set up a deal, and it wants to ensure the value of the contracted funds do not fall too drastically, a futures contract is one of the most effective ways to hedge risk. However, if a business operates or sells a product in a foreign market, a futures contract may not be the best option. In particular, if the exchange rate becomes more advantageous to the company or if the company’s sales in that market stall, it doesn’t want to be tied to a futures contract.

Cue options. An option gives you the ability but not the obligation to exchange currency at a pre-established rate. To illustrate, if you anticipate collecting 50,000 Japanese yen over the next two months, and you are worried about instability in the exchange rate, you may set up an options contract. Like a futures contract, you and a financial institution agree to a particular exchange rate. However, upon the end date of the agreement, you have the option to call or put. Call means that you buy currency at the pre-established rate, while put means you sell currency at this rate. In exchange for the option, you pay an option premium. In exchange for the premium, the issuer of the option has to accept the agreed-upon exchange rate if you decide to exercise your option.

Money Market and Debt Hedge

Debt and investments can also be helpful in foreign exchange risk management. Using debt and a money market account works similarly as using a futures contract. To illustrate, imagine a business owner agrees to sell a certain amount of a product for 10,000 Canadian dollars, but she is not going to receive payment for another three months. To address the potential of the exchange rate adjusting in a disadvantageous manner, the business owner takes out a loan for C$10,000. She, then, exchanges the C$10,000 on the spot market, and when she receives the payment, she repays her loan.

Aside from the interest associated with the loan, the business owners incur no additional financial risk, and because she knows up front exactly the rates she is paying, she doesn’t have to contend with uncertainty.

In some cases, business owners take the money they received from the spot trade and invest it in a money market account such as a Treasury bill. The interest from that investment helps to cover some of the associated costs of the loan.

Similarly, if a business has to pay a supplier, and it wants to ensure the exchange rate doesn’t fluctuate too drastically between the time it signs the contract and makes the payment, it can borrow local currency and exchange that for foreign currency on the spot market. Then, it can place the foreign currency in a money market account until it’s time to make the payment. In reverse, this process helps to stop the erosion of the currency’s value.

Managing currency risk for small businesses do not require an accounting degree or even any detailed knowledge of how the FX markets work. Essentially, small business owners only need to sit down, evaluate their risks and familiarize themselves with the potential solutions. When they have a risk management plan in place, they can accept foreign currency without worrying that it may erode their profits.

Disclaimer: Foreign exchange is hugely volatile and managing currency risk for small business requires professional help. Please consult your banker as well as your legal, accounting, and financial advisors for specific advice on managing foreign exchange risk for your small company.