Foreign currency fluctuations commonly occur in commercial transactions. Foreign exchange fluctuations can either be beneficial or harmful to the business. Businesses that transact in different currencies are exposed to forex risks.
An example is a Kenyan individual that opts to buy a certain commodity from an American company in dollars. Assuming that the Kenyan individual only has Kenya shillings then to purchase the goods, he will have to convert his shillings to dollars to make the purchase.
A foreign exchange fluctuation can work either for or against him. If the price is set at the time of contracting, and if the shilling loses against the dollar then he will need to pay more in order to meet the contractual price in dollars.
This is a simple example of how foreign exchange fluctuations affect international transactions. Much larger businesses feel the impact of foreign exchange fluctuations more. For example, a business that imports goods may feel the negative effect of forex fluctuations to the extent that the business may face massive losses as a result.
It is therefore important for businesses and individuals to learn how to mitigate the risk that arises from foreign exchange fluctuations. These fluctuations can work either for or against your business. A foreign gain can be beneficial because it can be reported as a business income. A foreign exchange loss can have a negative impact on the business.
For the last two or so months, the Kenyan shilling has lost significantly against the dollar. It is said that the loss of value is due to an ongoing dollar shortage. From media reports, the shortage is artificial in that, many investors are holding on to their dollars creating a shortage. The price of imports is, therefore, higher and the consumers feel more impact.
One way to mitigate against foreign exchange risk is to draft contracts that contain risk mitigation strategies.
One tip is to transact in your own currency. If it is a purchase transaction, then one can hedge against foreign exchange risk by transacting in own currency such that a Kenyan buyer would import goods in Kenya shillings. The seller will thus bear the foreign exchange risk.
In larger transactions especially those which are long-term in nature, foreign exchange risk clauses are drafted to reduce losses arising from forex losses. Long-term contracts will definitely be subjected to foreign exchange fluctuations in the long run. In most commercial contracts, the foreign exchange clause is triggered once the losses reach a certain threshold.
In some contracts, the risk is passed on to one party and the party agrees to bear the risk of the foreign exchange loss. This is especially in sales transactions where the seller passes on the risk of an international commercial transaction to the customer. This is important to note for Kenyan exporters who export various goods and services in the international market.
A third way to mitigate against foreign exchange risk is by setting the exchange rate in the contract. While the rate of exchange is set by market forces and the regulator when it comes to the performance of the contract, the rate can be pre-determined.
For example, shall the applicable rate be by the date of contracting, date of delivery, or date of payment of the goods? It is necessary to clearly define the applicable rate so as to avoid conflicts in interpretation.
The last option is to allow for contract review if the foreign exchange rate fluctuations are of a magnitude to affect the profitability and performance of the contract.