Currency hedging: What is it and what are some related strategies?

Do you buy, sell or invest in foreign currencies? When you make transactions in US dollars, euros or any other foreign currency, you’re exposed to foreign exchange risk. Read on to learn more about this risk, assess its potential impacts and get practical tips to protect yourself depending on your needs and situation.

Every business needs raw materials (suppliers) and sales (customers) to survive, so buying and billing are all in a day’s work. And since suppliers and customers don’t necessarily always bill or pay in Canadian dollars, it’s important to understand the risks associated with foreign currency fluctuations.

Foreign exchange risk means that the value of a foreign currency may fluctuate between when a transaction is concluded and when the amount is received or paid. If a company buys, sells or invests in US dollars, euros or any other currency, it is sensitive to exchange rate fluctuations, which can affect the profitability of a transaction or even cause an unexpected loss.

Import

You purchase US$100,000 worth of supplies from a foreign company. Based on the spot rate (current exchange rate) of 1.3200, you expect to pay CAN$132,000 for the payment that’s due in 60 days. However, at the time of payment, the spot exchange rate is 1.3800. That means you have to pay CAN$138,000 instead, which is CAN$6,000 more than expected for the same order.

Export

You sell €80,000 worth of specialized equipment to a client in France. When the transaction was concluded, the exchange rate was 1.4500, so you expected to receive CAN$116,000 after converting the euros. However, at the time of receiving the payment, the exchange rate went down to 1.3900, so you receive CAN$111,200 instead, which is CAN$4,800 less than expected.

When exchange rate fluctuations are unfavourable, your profit margins shrink, budget planning becomes more complex, and discrepancies arise between your forecasts and your actual cash flow. These unexpected things can weaken your company’s competitiveness, especially if your competitors have protected themselves against currency fluctuations and aren’t experiencing losses.

In a fast-moving market environment, sound risk management could help you avoid significant financial losses.

Foreign exchange risk may seem obvious when you’re doing international trade, but the risk is also present when you trade domestically. An agreement with a local supplier, payable in Canadian dollars, may also present risks. This is the case, for example, when the agreement includes a raw material (like oil, grains or steel) whose market value is traded in US dollars. That’s why you should assess foreign exchange risks on a case-by-case basis.

“By choosing a currency hedging strategy that’s tailored to its needs, a company can focus on areas they excel in—that is, producing and selling effectively. This means that the right support can create value.” – Benoit Marcoux, Director at Desjardins Capital Markets

Hedging exchange rate risk primarily reduces the uncertainty associated with foreign currency fluctuations. When you know the conditions under which transactions will be finalized, it will be easier for you to sign agreements that are sensitive to fluctuations, protect your commercial margins and plan your budget.

It’s also important to note that a hedging strategy is flexible. You can use various tools and strategies that can complement one another. In all cases, you need to take into account the company’s risk tolerance and ability to absorb shocks. According to Benoit Marcoux, Director at Desjardins Capital Markets, the main idea is to “use a careful and responsible management approach to limit the impact of rate fluctuations on the company’s results.”

In international trade, a hedging strategy can be a very smart choice. This strategy is a good safety net because it helps you secure initial transactions, avoid unpleasant surprises and move forward with more confidence.

There are a number of currency hedging instruments available to you, depending on what you need. But the important thing to remember is that the risk of loss is still present even if a currency’s exchange rate is relatively stable (gains similar to losses). The market is never immune to sharp fluctuations, especially during times of instability. That’s why having an appropriate currency hedging strategy is important.

Forward contracts are a common, accessible and flexible solution. A forward contract lets you lock in the exchange rate today for a future transaction, protecting you against currency depreciation. It’s a popular solution for businesses that are seeking stability and simplicity. While a forward contract is an excellent tool for managing foreign exchange risks, it doesn’t allow you to benefit from currency appreciation.

Import

A company needs to pay an invoice of US$50,000 within 90 days. Since the exchange rate is subject to fluctuations, the company signs a forward exchange contract with its financial institution at the spot rate of 1.3400. This means that in 90 days, the company will make a payment of CAN$67,000, regardless of the market rate on that day. The company is therefore protected against potential currency fluctuations.

Export

A Quebec company expects to receive US$70,000 in 90 days. Since the exchange rate could decrease by then, which would reduce the company’s gains, the company decides to secure a forward rate of 1.3400 with its financial institution. This means that in 90 days, the company will receive CAN$93,800, regardless of the exchange rate in effect. The company has therefore exercised sound risk management.

The plain vanilla option is the simplest and most common type of currency option. It gives you the right—but not the obligation—to buy or sell a currency with a financial institution on a specific date at a predetermined rate. To get the option, you need to pay a premium that’s based on the expected volatility, the duration of the agreement, the level of hedging provided and the amount of the currency being hedged.

Then, if the rate has moved in your favour, you’ll be able to benefit from the current rate. In contrast, if the current rate has moved against you, you’ll be able to exercise your option and complete your transaction at the rate that was originally agreed upon. In all cases, the upfront premium that you paid is not refundable. The main benefit of the option is peace of mind in terms of risk management, with no commitment beyond the premium.

Import

You need to make a payment of US$100,000 within six months. To protect yourself against a rise in the US dollar (while still being able to benefit from a potential decrease), you purchase a call option from your financial institution. Here are the details:

• Amount: US$100,000
• Exercise price: $1.35 CAD/USD
• Premium cost: CAN$1,560
• Current spot rate: 1.3300 CAD/USD

In three months, if the exchange rate is:

Above 1.35, you’ll be able to exercise your option and buy the US dollars at 1.35.

Below 1.35, you’ll be able to give up the option and buy the US dollars at the more favourable market rate.

This means that the option gives you a maximum price (1.35 in this case), while allowing you to benefit from a possible decrease in the US dollar. The only definite expense is the fixed premium of CAN$1,560.

Export

You’re expecting to receive US$100,000 in three months. To protect yourself against foreign exchange risks (decrease in the US dollar) while benefiting from potential appreciation, you buy a put option from your financial institution. Here are the details:

• Amount: US$100,000
• Exercise price: $1.3000 CAD/USD
• Premium cost: CAN$1,230
• Current spot rate: 1.3300 CAD/USD

In three months, if the exchange rate is:

Below 1.3000, you’ll be able to exercise your option and sell the US dollars at 1.3000.

Above 1.3000, you’ll be able to give up the option and sell the US dollars directly at the market rate that’s more favourable for you.

This means that the option guarantees you a floor price (1.3000 in this case), while allowing you to benefit from any potential appreciation of the US dollar. The only definite expense is the premium, which costs CAN$1,230.

The good news is that you can also create option strategies that do not involve a premium. This type of strategy combines two or more options, providing protection from unfavourable currency fluctuations while allowing you to benefit from a favourable currency movement. This means that the potential for gains is limited, but so are the foreign exchange risks.

A currency swap is a popular way to help you manage your cash flows. It lets you adjust the timing of when you pay or receive a currency so that you can better align your cash flows. It involves making two opposite transactions simultaneously.

It is useful, for example, if you buy US$500,000 at the current rate and resell it simultaneously using a six-month forward contract. That way, you avoid making two separate transactions a few months apart. In short, you minimize the risks of financial loss by combining two transactions into one.

This strategy is practical for businesses that have regular inflows and outflows in the same currency and want to optimize their international cash management.

For businesses that frequently pay or receive funds in the same foreign currency (US dollars, euros), a foreign currency account can simplify day-to-day management. The account can help minimize repetitive conversions, and reduce related costs and exposure to exchange rate fluctuations.

You may understand why it’s important to have a hedging strategy, but you might be unsure where to start, especially if you rarely conduct foreign currency transactions. Here’s how you can establish, implement and maintain sound risk hedging.

Start by listing all your foreign currency transactions, including purchases, sales, investments and repayments. Identify key dates, significant amounts and the most sensitive transactions. Doing this will help you understand where your main risks lie. Be especially careful not to develop a false sense of security from a relatively stable currency.

“You can win or lose in the markets. But should a company be gambling with its profit margin? Hedging is a fairly simple strategy that represents a small investment compared to potential losses,” says Benoit Marcoux.

Depending on your situation, you can choose to hedge all your cash flows or only the strategic cash flows, or to converge your inflows and outflows in a single foreign currency. Your choice will depend on your risk tolerance and the stability you’re seeking.

“When it comes to currency hedging, you can go with a very simple strategy or with a more complex one. Your financial institution can help you assess your ongoing needs, taking into account your knowledge and comfort level.” – Benoit Marcoux, Director at Desjardins Capital Markets

Each strategy has its advantages, depending on how predictable your transactions are and how much flexibility you need. Professional advice could help you avoid overly complex or inappropriate solutions for your business. It can also help you mitigate other types of risks associated with international trade.

A hedging strategy should evolve with you and your business. Make sure to clearly define each person’s role, monitor your timelines and forecasts, and adjust your hedging strategies on a regular basis. Closer monitoring gives you a better chance of having a strategy that meets your needs.

Foreign exchange risk may seem abstract, but its impacts can be very real. Fortunately, there are several hedging strategies available to help you protect your margins, stabilize your finances and move forward in the international markets with greater peace of mind.

Want to better understand your exposure to foreign exchange risk or explore your options for hedging foreign currency transactions? Contact our professionals. They’re here to help.

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