Foreign exchange risk management: How to protect your profitability

Caisses Desjardins

Quebec-based companies are increasingly doing business outside of Canada. For importers and exporters tapping into international opportunities, having a strategy to protect against exchange rate fluctuations is crucial to profitability. Otherwise, these companies may feel a significant impact on their financial performance.

Whenever the value of the loonie changes vis-à-vis the U.S. dollar, the euro or other currencies, it affects the price of goods and services that Quebec businesses import or export. For example, suppose a Canadian exporter makes a sale today in euros, but the order will not be delivered for six months. Since it’s impossible to predict the exchange rate when the company gets paid in six months’ time, the company is exposed to risk. Fortunately, there are proven methods to minimize this kind of risk (known as “foreign exchange risk”, “FX risk” or “currency risk”) and prevent what should be a profitable transaction from turning into a loss. Here are a few of the basic concepts behind managing foreign exchange risk.

«  Businesses take out insurance to protect their assets and cover the unexpected...but they unfortunately forget to protect their end goal: profit! »

4 steps you can take to minimize foreign exchange risk

The currency risk strategy a company chooses depends on its risk tolerance level. Some companies will decide to protect 90% of their currency risk, while others will determine that they only need to protect 50% since they can absorb the remaining impact of a negative variation in exchange rates. Companies that trade at least $1 million a year in foreign currencies have access to Desjardins traders. But for all companies, no matter, how much international business they’re doing, managing foreign exchange risk is a four-step cycle:

    1. Define the company's needs and challenges in terms of foreign exchange risk.
    2. Choose the best hedging strategy to manage this risk.
    3. Select hedging instruments.
    4. Implement/revise the exchange rate strategy according to changing needs and challenges.

Where does foreign exchange risk come from?

Foreign exchange risk occurs when a company receives payments in one currency but pays for its expenses in another. From the perspective of an importer, the risk is that the foreign currency will increase in value, since it means they’ll have to pay more for imported goods. On the reverse, for exporters the risk is that the foreign currency loses value against the loonie. If the foreign currency depreciates after the exporter makes a sale with an international customer, the exporter will end up with less in Canadian dollars than expected.

Companies are also exposed to foreign exchange risk when they produce a price list at the start of a season, long before they'll ever issue invoices to foreign clients, or when an infrastructure project requires payments upon completion of each step in a project. A company is exposed to risk as soon as it makes an official agreement with a supplier or client.

There’s no one-size-fits-all strategy for mitigating foreign exchange risk. A company’s risk exposure is influenced by many factors, including import-export volume, whether payments are made upon sale or at a later date, the currencies involved, and the countries where their customers and suppliers are located.

All currencies are constantly fluctuating in value, and the Canadian dollar is no exception. Decisions about the Bank of Canada's key interest rate, energy prices, geopolitical conflicts, foreign acquisitions of Canadian businesses and many other factors affect the value of our currency. It’s incredibly difficult to predict exchange rate movements, and forecasts by analysts are not always reliable. That’s why it’s so important for companies to have a policy in place to minimize this risk and protect their profitability.

How to minimize or even eliminate foreign exchange risk

Many financial products are available to business owners to help them protect themselves against foreign exchange risk:

  • Forward contracts, where the exchange rate is set when the sale is made, but payment is made in the future
  • Currency options, which gives the company the right (but not the obligation) to exchange a set amount of foreign currency at a specific rate in case the foreign currency loses value
  • Currency swaps, which lets a company “swap” their forward contract for one with a different date—also a good option for companies with cash flow challenges, as it eliminates foreign exchange risk 

With so many complex factors at play in currency fluctuations, it’s not worth your while as a business owner to spend time trying to predict currency movements. That's why it's critical to think ahead with a strategy to minimize risk. Your trader can work with you to find the right exchange rate management strategy for your company, taking into account how your company operates, your risk level and your risk appetite. Your industry and profit margins will also have an impact on your hedging strategy. The smaller the profit margin, the more critical it becomes to have a hedging strategy in place. Finally, remember that the main goal of a hedging strategy is to protect your company's profitability, and not to speculate on fluctuations in foreign currencies. Your company should be focusing on its primary concern—operations—and minimizing or eliminating risk in areas outside your expertise.

About the author

Martin Villeneuve, CFA – Manager, Foreign Exchange, Derivatives

Martin Villeneuve has a Bachelor of Commerce (Finance Major) from McGill University. He specializes in corporate and institutional clients involved in international trade and helps them with foreign currency and interest rate swaps. After working in bonds, he moved to currency and interest rate derivative products, where he’s been for more than 10 years. His role is to advise companies on managing foreign exchange risk and interest rate risk by providing them with custom-designed tools and strategies. Martin has held the title of Chartered Financial Analyst (CFA) since 2011.

The opinions expressed in this article are those of the author and do not necessarily represent the opinions of the Chamber of Commerce of Metropolitan Montreal. The Chamber shall not be held liable for content published.

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