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Currency fluctuation questions from readers answered

Question from Dean: Are many currency fluctuations caused by traders trying to make a fast buck? Is this legit? Is it socially necessary?

Michael Elliott - managing director, head of corporate and commercial foreign exchange sales, HSBC Bank Canada: The global foreign exchange market trades an estimated $4 trillion in daily volume. While there are high frequency trading accounts involved in the foreign exchange market, it is unlikely that they could consistently manipulate a market of this size. Both speculative and hedging activity are required to make the market efficient. Without the depth provided by speculative activity, it would be extremely difficult for the hedging flows to be executed without significant market disruption.

Jean-François Lamoureux - research analyst, Export Development Canada: Freely-traded currencies like the Canadian dollar, Euro, British pound and Japanese yen are essentially commodities. Like for any other commodities (oil, wheat, lumber, gold), daily trading volumes for freely-traded currencies are significant (in fact, the global foreign exchange market is known to be world's largest financial market with over USD 3 trillion of turnover per business day). And like for any other commodities, the majority of the trading activity that takes place for freely-traded currencies originates from traders "trying to make a fast buck" as you indicate.

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This trading activity is legal in Canada and in other industrialized countries. Because the majority of trading volumes for freely-traded currencies stems from speculation, it is true that foreign exchange traders collectively detain the power to move an exchange rate in the direction that they want. No central bank in the world has the currency reserves to match the foreign exchange market's depth (which is why the Central banks of countries that have a freely-floating currency rarely try, these days, to intervene in currency markets)! But foreign exchange traders ultimately take their cue from hard economic data. In other words, the "fundamentals", such as economic growth, inflation, current and capital account balances, fiscal situation, interest rates and terms of trade (the value of a country's exports relative to its imports), all guide the direction of exchange rates for freely-traded currencies.

Fixing the exchange rate at a socially or economically desirable level can potentially be the right choice for small economies where executing an independent monetary policy is difficult. Fixed exchange rate regimes are, however, difficult to maintain over long periods of time and can lead to turmoil when they are abruptly ended (e.g. Thailand in 1997). For most large economies, including Canada, having a freely-floating currency carries many more advantages than disadvantages.

Brendan McGrath - Brendan McGrath - manager, Treasury Solutions, Custom House, a Western Union Company: While the majority of flows in foreign exchange markets are speculative in nature, the incredible size of the market makes it difficult for one trader or a group of traders to move the market in a meaningful direction for personal gain. Global foreign exchange market turnover is around $4 trillion per day on average, which is about three times the average monthly dollar volume traded on the New York Stock Exchange. It would take someone with incredibly deep pockets to influence this market, and as such there is no insider trading in currencies. There are also major players in currency markets, such as central banks, whose mandate it is to stabilize their country's currency rather than speculate to make money. Take Japan for example, a country so dependent on exports that their central bank has trillions of yen at their disposal as a defense against their currency getting too strong. There is no single trader in the world that would be able to stand up against a market moving force like a central bank. As far as fluctuations in currency markets are concerned, there are many different forces at play. The ebb and flow between businesses and institutions that need to buy and sell currencies for business needs will cause fluctuations in currencies. Speculators also have a big effect on movements, although the liquidity they add to the market makes it the most efficient financial market on earth. From a social standpoint, it can be argued that due to this fact speculators are good for the markets in that they make it function better.

Question from Joanne: How should a small business hedge against currency fluctuations? What is the most cost-effective way?

Michael Elliott: There is a spectrum of available hedging alternatives available to small businesses. The "ideal" hedge will vary based on the company's risk tolerance and sophistication, the level to be protected, and the amount the client wishes to spend. You should consult with your bank for a strategy that best suits your needs. Companies should try to match exposures in both the balance sheet and the income statement, to try to offset foreign assets and liabilities - or revenues and costs where possible. The following hedging strategies could be considered:

  • 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.

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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.

Question from Paul: Doesn't hedging mean you surrender possible gains as well? Is it really worth it?

Michael Elliott: Hedging is meant to mitigate negative impacts to the underlying business. While there are generally costs involved, it doesn't necessarily mean you are giving up possible gains. When any adverse move causes fiscal pain, but positive moves are not necessarily offsetting, then the cost of hedging is definitely worth while. The vehicle used to hedge the currency risk can be structured to allow for participation in favourable moves. However, the hedge itself will have to be at a less favourable level. This means you do get to participate in the upside, but you have to be open to some of the downside as well.

Jean-François Lamoureux: This will depend on the proportion of a company's foreign exposure that is hedged and the type of hedging instrument used. It is true that with foreign exchange forward contracts ("forward"), possible gains are nil if the exchange rate moves in manner that is favourable for the company. This will be all the more true if a company has hedged 100% of its foreign exchange exposure. With a forward, the "cost" for the company (note: there is no out-of-pocket cost associated with purchasing forwards) of eliminating all of the risk tied to a negative evolution of the rate of exchange (from the company's perspective) is its inability to benefit from a positive movement in such exchange rate.

Contrary to forwards, currency options do allow firms to benefit from favourable movement in the exchange rate. However, they either involve an upfront cost or are structured in ways where companies have to accept some exposure to a negative movement in an exchange rate in order to reap some benefits if the exchange rate movement is positive for the company.

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For the majority of companies, the goal of currency hedging should not be to generate incremental profits. Currency hedging should be seen as being first and foremost a risk management activity that aims to protect a companies' profit margins. In that sense, it is definitely worth it.

Brendan McGrath: Hedging foreign exchange risk with a forward contract does protect you against an adverse move in the currency but also means you cannot participate in a favourable move in that currency. Businesses hedge currency risk in order to protect budgeted rates rather than to make money on a currency move. While gaining the best rate on a hedge is always an attractive proposition for corporate treasurers, protecting the company's bottom line should be job number one. Any company with a foreign currency exposure should have a budgeted rate in mind that they target to protect, rather than speculating and waiting for the rate to improve. We all too often see companies choosing to wait for a currency to swing in their favour and end up locking in losses when that move doesn't materialize. An old adage that treasurers and risk managers need to remember is that no one has ever gone broke locking in profits. While hedging with a forward contract does not give you any upside potential, a currency option does give you the ability to protect your bottom line while allowing for upside gains as well. Currency options give the holder the right but not the obligation to buy or sell a currency at some time in the future. That is, they can protect their bottom line while still allowing for full participation in any favourable move. This flexibility does come with a cost however, and can sometimes be prohibitively expensive for cash poor organizations to afford. Options are akin to buying insurance on a currency in the hopes that you won't have to use it, but with the peace of mind that you are protected should the unforeseen event happen. Using an option strategy that combines the purchase and sale of an option can allow you to protect your bottom line while giving you a limited amount of participation in a favourable move, so hedging does not necessarily mean you have to give up any chance for gains. A robust hedging strategy is one that combines options and forwards as well as unhedged positions in order to provide the optimal result for the company. Companies with tight profit margins will usually hedge a larger proportion of their overall exposure as even a small move in a currency can impact their bottom line drastically. At the end of the day hedging, regardless of the tool used to do so, will provide value to an organization that is aiming to protect its bottom line.

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