In the business of trading internationally? If so, then a formal foreign exchange risk management practice should be part of your business plan, or you are likely putting your profits and cash flow at unnecessary and potentially considerable risk.
Foreign exchange risk revolves around changes in exchange rates that can occur between the time a price is set in a foreign currency, goods/services are sold and a foreign currency payment is received, resulting in the vendor getting less than it bargained for, or a buyer paying more than anticipated.
The longer the sales cycle – the time between when prices are quoted and when money comes in – the greater the currency risk. If markets are volatile, even short sales cycles can mean high risk.
While the concern might appear obvious, experts say the majority of Canadian exporters fail to accurately factor currency risk exposure into their deals.
“I once worked with a company that grew its revenues from $35 million to $70 million over five years. Despite the revenue gains, their profit stayed flat year after year. They hadn’t adequately taken the currency risk into account,” says foreign exchange expert Normand Faubert, the principal of Montreal-based consultancy Optionsdevises.
Like many companies that run into similar trouble, Mr. Faubert says the currency risk exposure was improperly measured, resulting in an ineffective hedging strategy.
“No one understood that the cumulative currency exposure was in the millions of dollars,” he says. “Every time the USD moved up by one cent, the company had calculated the impact on the bottom line was about $30,000, but in fact it was more than $200,000.”
How did such considerable losses slip under the radar screen? Mr. Faubert says the culprits were the impacts of a steadily rising Canadian dollar and the company’s belief that the absence of noteworthy foreign exchange losses in its financial statements indicated that the currency exposure was properly managed.
“The risk appears when a company makes a decision regarding price in a foreign currency, but that risk is not typically apparent in the financial statements until an invoice is generated,” says Mr. Faubert. “This is when the risk becomes an accounting reality – at a much later time then when the risk actually arises.”
Unfortunately, a recent EDC study showed that even when companies engage in currency hedging, most do so in an ad-hoc fashion.
“Fewer than one out of five respondents had written policies guiding their ‘FX’ risk management practices. That’s a key problem,” says EDC trade research analyst Jean-François Lamoureux.
“Companies don’t know when the currency risk begins or how much they are losing. That’s pretty scary.” Jean-François Lamoureux.
Mr. Lamoureux adds that while many companies believe managing foreign exchange risk is too complex, costly or time-consuming, others view hedging as a speculative activity. Others simply don’t know about hedging instruments and techniques to mitigate currency risk.
Despite this, he says numerous studies have shown that managing foreign exchange risk offers benefits including minimizing the effects of exchange rate movements on profit margins, increasing the predictability of future cash flow, eliminating the need to accurately forecast the future direction of exchange rates, facilitating the pricing of products sold in export markets, and temporarily protecting a company’s competitiveness if the value of the Canadian dollar rises.
Mr. Lamoureux adds, “Developing an FX policy requires some time and effort by companies. But once systems and processes are in place, it doesn’t take as much time to manage currency risk, and the financial rewards are typically meaningful.”
Canadian banks and other service providers offer financial hedging instruments such as forward contracts, which allow a company to set the exchange rate at which it will buy or sell a given quantity of foreign currency in the future (on either a fixed date or during a fixed period of time). EDC’s Foreign Exchange Facility Guarantee (www.edc.ca/fxg) helps free working capital for Canadian companies that purchase forward contracts from their financial institution partners.
Before using such products, however, companies seeking to mitigate their FX risk should invest in education.
This fall, EDC will release a how-to guide on developing a basic FX program, which it produced in co-operation with Mr. Faubert.
Noting that while the negotiable nature of currency hedging instruments means “a company that has a strong understanding of banking services and the way the hedging market works naturally pays less,” Mr. Faubert emphasizes, “The most important thing is to identify, recognize and measure how currency fluctuations – over which nobody has control – can have a negative impact on a company’s profitability.
“Strategies are important, but before you can elaborate a strategy to manage currency risk, you need to clearly understand how this risk affects your company. Take the time to do this step properly and you will more fully benefit from your currency hedging activities.”