by Mark Mullis
Money is money, whether it's US Dollars, British Pounds, Euros, Thai Baht, Swiss Francs, Norwegian Krone or another currency. But each form of money is only legal tender in certain countries, making conversions from one form to another—foreign exchange—essential to international business. The fluctuations in these exchange rates create risks that businesses need to manage. In many industries, businesses can minimize those risks by dealing only with local suppliers. That isn't an option in the travel industry unless you are a specialist in domestic travel.
Foreign Exchange Rates
Some countries establish a fixed rate of exchange for their currencies, as in Belize where BZ$2 is officially pegged to US$1, but in most countries, exchange rates fluctuate on an open market. The rates vary depending on factors like interest rates, economic trends, supply and demand, and inflation.
When travelers exchange money overseas, they receive the nominal exchange rate for that currency, which sets the value on a particular day. Businesses are also likely to be impacted by the real exchange rate, which is determined by the currency market for setting rates on future transactions.
Risks Created by Foreign Exchange
Foreign exchange creates several kinds of risks that impact any company conducting international business. These risks include:
- Portfolio risks. Cash flows from overseas operations fluctuate with currency exchange rates. The impact of these risks are usually relative minor and don't need to be actively managed.
- Structural risks. Companies experience structural risks when their cash inflow reacts differently to currency rates than their cash outflows. These risks can impact the company's cash margin on sales and can even result in an overall negative cash flow.
- Transaction risks. Transaction risks occur due to the time difference between when a contract is made and when the payment is made. The exchange rate between currencies may have significantly changed during that time, meaning the cost in the company's home currency is greater than anticipated.
Travel agents and other travel businesses are exposed to all of these kinds of risks. Customers frequently pay the agent in their home currency, with the agent responsible for converting and settling with the travel provider.
Travel agents may also experience significant declines in business when exchange rates make international travel more expensive for consumers. Some companies that focus on domestic travel may gain additional business.
Managing FX Risks
Companies can manage foreign exchange risks, typically through locking in agreed upon rates or participating in transactions to hedge the risks and reduce the impact of changes in exchange rates. Forward contracts, options and derivative transactions lock in specific rates and guarantee the ability to buy and sell currency at specific rates at a future date. The disadvantage of these contracts is that they can be complicated to set up, track and manage.
Some companies choose to purchase and hold foreign currency in advance to make payments directly in local currency without being affected by the exchange rate at the time of payment. Companies may also have local bank accounts for countries that they operate within so that they accept and make payments in local currency without the need for conversion.
Virtual card numbers (VCNs) allow travel companies to pay suppliers in local currency with ease and avoiding unnecessary costs. Where a travel company holds local currency VCNs facilitate payment of the supplier in that currency and allow the travel company to settle with the VCN provider in the local currency too.
Where the travel company does not hold local currency, VCNs allow the supplier to be paid in their local currency while the travel company settles with the VCN provider in their own currency, avoiding FX mark ups and cross-currency fees that other payment methods may occur.
Beyond facilitating international payments and saving companies money on these transactions, VCNs provide protection against fraud which can be a bigger risk when dealing with overseas businesses.
Managing cash flows is an important part of any business. In the travel business, that means managing cash flows in multiple currencies. Incorporating payment methods that reduce the impact of fluctuating exchange rates, as well as avoiding unnecessary fees, can be an important contributor to a travel company's profitability.