Understanding Foreign Exchange Risk

Thanks to the internet, what once was the domain of large bank trading rooms, foreign exchange markets over the past few years have been opened up, so the average business can get a better understanding of how the movement of different currencies affects their revenue stream. This “FX Risk” applies to a wide range of industries that deal outside of Canada. Hopefully this article will help to demystify the foreign exchange markets so your business will be better positioned to manage your currency exposure.

There are many questions that need to be answered before someone does business in a foreign market, such as; “What are the tax implications of dealing overseas? What are the customs regulations and/or import & export restrictions that I will need to deal with? How will my revenue be affected if the value of the Canadian dollar changes?” All of these questions can be answered favorably with just a basic understanding of each area but for the currency markets, a little more time and effort is needed to understand how to create a proper currency strategy. Once you gain that understanding, you will be able to see the results in a much improved bottom line.

A properly constituted currency management plan should be looked at by any business that has foreign currency revenue from $10k to $100 million a year and having a proper plan in place will always help your bottom line. A sound FX plan will have some or all of the following attributes:

Market Knowledge -The key to any currency management program is to understand the factors that can affect the value of the Canadian dollar over both the long or short-term. No longer are the workings of foreign exchange kept in the draconian back rooms of large global banks. With the advent of internet technology the markets are now completely transparent and more open than they have ever been. Whether it is changing interest rates, government deficits, mergers and acquisition activity or changing oil prices, each company now has the information at hand it needs to make informed decisions on the direction of the currencies. Companies like GFX summarize these factors and put them together into market commentaries that enable businesses to have the information they need to make informed decisions. If any readers would like to receive my morning FX commentary, please feel free to drop me a line and I will include you on the list.

Execution Strategies -The next big component of a currency management program is both the method and timing of FX execution. Many companies, still to this day, receive their foreign currency payments into their Canadian dollar account and their financial institution just exchanges the amount at horrible rates, without consulting the client. Another favourite way to convert foreign currency is just to call a bank and exchange the funds at the “day” rate and the client never fully understands what the opportunity cost of that exchange was. Today with market transparency, a company can do their foreign exchange over the telephone or in a secure online environment, with specialized financial services companies and are able to compare rates from different financial institutions to achieve much better results.

Companies are no longer just restricted to dealing at a currency provider’s currency price, but much like they can in the stock market, a business can leave a market order with a financial institution and when the market hits the appropriate level the exchange is executed. Companies can now take advantage of leaving their currency orders in the same marketplace that the large banks use and take advantage of the currency movements around the world at any time of day or night, giving them the opportunity to save thousands of dollars.

Hedging Strategies – “To hedge or not to hedge? That is the question”-(*with apologies to William Shakespeare). Hedging a foreign currency exposure is simply a plan that any business can put in place using different financial instruments to take away the risk of adverse currency movement. The most common financial instruments that are used to hedge FX exposure include:

A Fixed Date FX Forward Contract – If a company knows that it will be taking delivery of a foreign currency at some point in the future if can enter into a contract to lock in the FX rate today and then arrange for the physical delivery of the currency on a fixed date at the agreed rate. This product takes away all the risk of a currency rate moving against you before you take delivery of the actual funds and is a well used tool by FX professionals.

An Option Dated FX Forward Contract -same as a fixed date option contract but delivery of the actual funds is much more flexible and can be arranged any time during an agreed period, usually around one month.

A Currency Option -gives the buyer of the option the right but not the obligation to buy or sell a particular currency at an agreed price at some point in the future in return for paying a premium price up front. The great advantage to a currency option over a forward contract is that it gives the owner of the option the ability to take advantage of any favourable currency moves, but limits any potential loss if the currency moves against you.

Instrumental to any foreign currency management program is the understanding of the different factors that come into play when considering a strategy. Things to look at include the present exchange rate for the currency pair in question, the trend of the currency pair over the last days, months and years and the prognosis of the currency pair by industry professionals. All-in-all, if you take the time to review these products and strategies, I am sure that you will see a big improvement to your bottom line. If you have any questions regarding anything I have touched on in this article or you would like to receive a copy of my morning FX commentary, please drop me a line and I will be very happy to oblige.

Article by Mike Smith, President, GFX Partners Inc.

Mike Smith is President of GFX Partners Inc and is the host of their “lunch and learn” program that teaches the basics of foreign exchange to business across Canada. To learn more about how GFX can save you time and money on your FX transactions contact Mike at 416-217-3095 or at msmith@gfxpartners.ca

Financial Tip…from James Phillipson

If you are not hedging your foreign exchange cash flows and they are a significant part of your business, start doing so by implementing the following steps:

• Forecast your foreign cash flow over the short-term (I would suggest three to six months, for a start, unless your business cycle is a very long one) by reviewing your accounting and purchasing records. Be as accurate as your systems allow but be prepared to use ranges where precise data is not available e.g. US $100,000 to $120,000 inflow between Dec. 10 and Dec 31;
• Ensure that you list both your expected inflows and outflows;
• Ascertain if there is a way to match inflows & outflows so that you have a “natural hedge;”
• Aggregate transactions into groups that have similar time frames and calculate the net cash flow expected in that period;
• Consider that hedging an expected cash flow is intended to be done at the time that you initiate the transaction that gives rise to the cash flow i.e. for an exporter, it would be when you receive the order from the customer and for an importer, and it would be when you place the order with your supplier. This can be made much more complex, but this is a reasonable starting point for most businesses;
• Ensure that your entire management team and board of directors understands that eliminating the risk of adverse swings in FX rates also eliminates the opportunity that may present itself if exchange rates swing in your favour. This is an insurance policy and by taking the policy you lock in your rate. This is a critical issue where you will have other members of the management team or board of directors aware of your success, or who will use hindsight to judge your performance;
• Many businesses hedge a proportion of their FX exposure that gives them comfort that they will be able to manage the cash flow commitments that they have calculated e.g. 80% of the expected net cash flow in December.
• Make arrangements with your bank or an independent foreign exchange service provider to ensure that you understand the logistics required for each transaction and if your bank is the provider, what changes are necessary in your facility agreement.
• Shop around – there are many different sources of foreign exchange and the rates they offer can vary considerably.
• Try it. Do a small transaction, relative to your FX cash flows and get comfortable with the process and the savings.

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