- A forward contract carries no actual cost, other than interest rate differentials and opportunity cost from forgone favourable moves. A forward hedge is a contractual obligation with a fixed rate and date. This hedge provides absolute certainty in terms of your future dealing rate. You are fully protected against adverse currency moves, but you are also prevented from participating in favourable moves.
- An option window may be placed on a forward if the exact date the funds will be required is not known. The contract may be "drawn down" at any time during the specified window.
- A currency option can be considered if you want to be able to benefit from upside moves. An option can be simple or complex and doesn't necessarily open your business to more risk than a forward.
Jean-François Lamoureux: Before doing any form of hedging a company, regardless of its size, first needs to determine what the amount and the duration of its exposure to foreign exchange risk is. The amount of the exposure corresponds to the quantity of foreign currency that the company will (or expects to) receive in the future minus the expenditures in that same currency that the company will (or plans to) have. The duration is often calculated as the period of time between the moment that an order is confirmed and the moment when payment is received and the foreign currency converted to Canadian dollars (note: in reality, exposure truly begins when an exporter sends a quote or a price list to a potential foreign buyer).
After establishing what the exposure is, a company needs to determine how much of that exposure it wants to hedge. A company's financial ability to withstand a large unfavourable movement in the exchange rate between the Canadian dollar and a foreign currency and management's tolerance to risk are key elements that normally guide this decision. Small businesses usually have a lower capacity to absorb the negative impact on profit margins that an appreciation of the Canadian dollar brings about. Also, the greater the proportion of a company's total sales that are paid in foreign currency, the more vulnerable it will be if the loonie soars during the exposure period.
Once a company has established how much of its exposure it wants to mitigate, it can then approach its banker or a foreign exchange broker who can propose appropriate hedging instruments. For most small businesses, foreign exchange forward contracts do the trick and are extremely cost-effective.
Brendan McGrath: Small businesses have a few different options to protect themselves from currency fluctuations. The first and most common way to hedge against currency fluctuations is with a forward contract. A forward contract allows you to lock in a rate to buy or sell a certain currency at a particular rate for some time in the future. For example, if you need to purchase equipment from the US in three months time and the price is quoted in US dollars, you are at risk that the USD will appreciate during those three months, thus making the product more expensive. In order to mitigate the currency risk associated with this deal, you would book a forward contract to buy USD and sell CAD in three months time. On the day you need to pay the US dollars, you would simply wire the pre-determined Canadian dollar equivalent to your FX provider and they will forward the USD on to the US vendor. Forward contracts are the most efficient tool available to hedge currency risk as they are simple to understand and require no upfront fees. One thing to remember is that a forward contract rate will be the same regardless of where the currency markets go, so you are protected from downside risk but cannot participate in a favourable movement either. Some FX providers will require that clients post collateral in order to secure a transaction like this. A second tool available to small businesses is a currency option. A currency option gives the holder the right, but not the obligation to buy or sell a currency at some rate in the future. Due to this flexibility, a currency option requires an upfront premium as it gives the holder the ability to protect themselves from an adverse move in a currency while allowing them to participate fully in any favourable move. There are option strategies that allow clients hedge currency risk without paying an upfront premium that involve the purchase and sale of an option. In these cases, clients can protect themselves from an adverse move in a currency, but their ability to participate in a favourable move is also limited. This can be an ideal situation for some clients as it gives protection, participation and comes at zero cost.