“Entrepreneurs: arm yourself against American currency turmoil in time”

The increasing likelihood of an American interest rate increase and the impending presidential election in the US are causing increased turmoil on currency markets. Entrepreneurs could spare themselves potential misery by covering foreign flows of money in time, says Joost Derks of the Dutch Payment and Exchange Company in this column.

Entrepreneurs doing business with dollar countries are headed for an interesting period. Janet Yellen, chairperson of the American Federal Reserve, was surprisingly optimistic about the economy in a speech on Friday, 26 August. This indicates the likelihood of an increase of interest. The next meeting of the Federal Reserve is planned for the 20th and 21st September. A month and a half later the American presidential election will take place. Both an increase in interest rates and the uncertainty of the election can affect the exchange ratio between the euro and the dollar.

If the Federal Reserve increases interest rates in a few weeks, the interest differential between Europe and the US will remain relatively small. It will, however, become more obvious that the central banks on both continents are heading in opposite directions. Parties often anticipate new interest increases on currency markets in these types of situations. Moreover, the contrast between the two main American presidential candidates has not been this great in decades. Unless Hillary Clinton succeeds in taking a clear lead on Donald Trump in the polls in the coming weeks, the electoral uncertainty may increase substantially.

For companies it is now important to protect the flows of money in dollars against the fluctuations of the dollar rate. A currency option gives the right to exchange dollars for euros at a predetermined ratio. The price of a currency option is partially determined by the level of volatility. Volatility is a much used indicator that shows the liveliness of currencies, and, for example, also of shares. Experience shows that this volatility can increase significantly as an important date approaches. For example, in the run-up to the Brexit referendum the British pound started fluctuating more and more. Due to the uncertainty of the result, the price of protection in the form of currency options increased enormously.

Parties who now buy currency options have the luxury of not worrying too much about American developments in coming months. In the most favourable scenario they could even be left with something afterwards. For example, a fruit trader who safeguards himself against a decrease of the dollar with a currency contract will benefit when the dollar increases sharply. Of course, he will not recover costs from purchasing the contract, but the payments of his customers in dollar countries are worth more in euros. His turnover will then increase without him running the risk of a similar decrease if the dollar collapses.

A currency option gives the buyer the right to exchange an amount of money from one currency into another currency at a predetermined date. The price of a currency option is determined by, for example, duration, interest differentials and volatility. As the volatility increases, the seller will factor in a higher premium for compensation of the larger risk that the value of the underlying currency might rise or drop sharply.

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