With foreign exchange (FX) risk, currency hedging, forward contracts and foreign versus domestic cashflows, the FX world can seem complicated for those not well versed in international payments.
But, put simply, if your business buys stock from a foreign country, it is highly likely that you will be exposed to FX risk, and could benefit from an effective risk management strategy – even if you pay in sterling.
As we enter the second quarter of 2025, this year is proving no less turbulent than the previous five. US president Donald Trump’s tariffs and potential trade war are just the latest issues to challenge brands and retailers, meaning all businesses should be doing what they can to mitigate potential bumps in the road.
To help you decode the FX world and assess your level of risk in these uncertain times, Drapers asks Alex Lawson, director of hedging for EMEA at global commercial payments solutions provider Convera, what fashion businesses need to know – and do – to reduce their FX risk.
What is FX risk? How can risks impact fashion businesses?
Foreign exchange risk relates to adverse movements in the exchange rate between one currency and another for those with an underlying cashflow need.
Within the fashion industry, supply chains are often international – particularly involving the Far East – resulting in exposure to dollars, yuan or other local currencies, while sales often occur in pounds or euros.
If today’s sales proceeds are used to buy tomorrow’s stock, a fall in the value of the pound relative to the dollar, for example, will mean you have less purchasing power.
Unless you can adjust your future sales prices accordingly, this will likely mean reduced profit margins.
In this era of global uncertainty and inflation volatility, what are the key drivers of FX risk?
Unfortunately, from a business planning perspective, currency markets are impacted by nearly everything, from geopolitics to domestic economic factors.
That said, if there is a primary influence, it would be interest rates. In normal markets, rising interest rates in a country make its currency relatively more attractive and vice versa.
We are, however, in far from normal market conditions. Much of the current world order – at least with regards to trade – is being upended by events across the Atlantic, resulting in a reassessment of risk that is overriding normal rules.
What is currency hedging against FX risk?
Currency hedging relates to any mechanism or process a business follows to reduce the impact of changing exchange rates. This could be via the use of financial instruments to fix the rate of exchange for the future or limit the potential for adverse movement – known as forward contracts or currency options; using proceeds from sales in a foreign currency to pay invoices in the same currency without first converting back to domestic currency – known as natural hedging; or even substituting overseas suppliers for domestic sources to reduce or remove exposure altogether.
What are the benefits of hedging and risk management for fashion businesses?
The common misconception is that hedging has been successful if the exchange rate achieved is better than would have been the case had no hedging taken place – known by some as “beating the market”. However, there are far too many variables that impact exchange rates to ever make this consistently achievable.
As such, the primary benefits are certainty over the value of future cashflows and therefore profits against a defined budget or target rate – allowing for better planning, visibility and understanding of residual risk to increase confidence and, with a robust and simple hedging strategy, the reduction of distractions of management time that would be better spent on core business activity.
Are there risks associated with hedging?
The idea of hedging is to manage risk, not add to it. However, there are considerations to take into account before transacting. For example, there is opportunity risk: had you not hedged, the rate you achieved might have been more favourable. Or the risk that your requirements change and the hedge is no longer suitable, which may incur a cost to amend or cancel. Always ensure you understand all the implications before going ahead and seek expert advice if needed.
Margins are getting tighter, costs are increasing and many fashion businesses have passed costs on to consumers. The world could also be impacted by president Trump’s tariff war. How does FX risk management fit into this?
Let us take a theoretical mid-range high street brand selling in the UK, which sources its product from producers in Vietnam and pays in US dollars. For the sake of simplicity, we will assume an average cost of a garment is $8 with an average retail price of £20. Operating costs – salaries, rent, rates and marketing – account for £11 per garment. At a GBP/USD rate of £1/$1.30, the production cost is £6.15, leaving a before tax profit of £2.85. A 4% drop in the GBP/USD rate to $1.25 – which occurs quite regularly – pushes up the cost of the garment by 25p.
With no change to the retail price, this represents just under a 9% reduction in profit. In an environment in which minimum wages, rents and electricity are all rising, and consumer demand and willingness to pay higher prices is softening, is ignoring currency exposure an additional risk worth taking?
Who should consider a hedging and FX risk programme? Is it only global companies and big businesses that need to engage in FX risk management? Any size of business in the fashion industry could be exposed to currency risk and there is an argument that everyone should consider hedging. However, there are nuances within that. For those operating at the luxury end of the fashion industry, where mark-ups are very high and customers are much less sensitive to price, typical currency fluctuations may have a limited impact on their business compared with those with much tighter profit margins and less price elasticity for whom even a 1% or 2% erosion by currency moves could be material.
That said, from time to time, currency markets move far more substantially. The pound
fell 13% against the dollar overnight following the Brexit vote, 12.5% at the outbreak of Covid and 8.5% in reaction to the Liz Truss mini-Budget in 2022. The overall peak to trough from 2021 to 2022 was just under 25%. Even high-end brands that may have added complexity in exposure such as overseas stores or franchises with both sales and costs in various currencies, should undertake a proper evaluation of the risk as a first step.
I would also include those that are invoiced in pounds by their overseas supplier, as the price they are paying incorporates the currency risk the supplier carries, usually with a healthy safety margin, meaning prices could be cheaper if they managed the risk themselves.
Finally, what advice do you have for fashion brands and retailers when it comes to managing FX risk beyond 2025?
The first step is always to get visibility of your exposure to currency risk. Don’t assume that fluctuations are small or that they always even out in the end.
Plug in some assumptions on rate movements to quantify in pounds and pence what the impact might be for your business first, and then to speak to an expert to get advice on what to do to manage that risk.
