It’s a secret your financial statements aren’t telling you. Chances are good that your company isn’t handling its foreign exchange (FX) risk properly. That could seriously impact your profitability, competitiveness, and bottom line—especially within the context of unpredictable turbulent currency fluctuations.
“FX risk is neglected by many Canadian companies due to a lack of understanding of the real nature of the risk,” says Normand Faubert, President of Optionsdevises, a firm that specializes in managing FX risk. “Financial statements don’t tell the tale.”
In fact, fewer than one of every five Canadian exporters report having an FX policy in place. Faubert says companies tend to go straight to hedging tools to deal with FX risk which, similar to insurance, will lock in an exchange rate. But not understanding a company’s unique exposure to FX risk means the hedging tool purchased may be inaccurate or inadequate.
To explain why, Faubert provides a fire-risk analogy. “Insurance is something that comes after a preventive process. When you build a house, there are building codes to make the house fire-resistant. Next, the people living there conduct activities in such a way as to avoid fires. And finally, just in case these preventive measures fail, they buy fire insurance.
“The problem with the way most companies handle FX risk is they get the insurance without a proper analysis of how FX fluctuations impact their business. Hedging instruments are essential, but so are strategic measures.”
Companies should look internally to manage the risk
Unlike fire prevention, however, there are no laws or regulations on managing FX that exporters can simply follow.
“Companies also tend to view FX fluctuations as an external financial market matter, as well as something that’s beyond their control,” says Faubert. “But in fact, companies should first look internally at their business operations, where cash flows are generated and where it is possible to strategically manage the risk.”
The first step is to undertake a thorough analysis of how FX is impacting a company’s profits, and this will be different for every company. Some of the areas a company might analyze are how it sets an export price, how long its business cycle lasts, and the time between making the sale and getting paid.
For example, many companies start to focus on their FX exposure only once a sale is confirmed or, even worse, when account receivables are created through the invoicing process. Yet, the price for the goods and services sold may have been set months earlier, when the exchange rate was quite different. “Once this detailed analysis is completed, companies are in a better position to develop an FX policy, to deal strategically with currency fluctuations,” Faubert says.
Jean-Francois Lamoureux, a Senior Political Risk Insurance Underwriter at EDC agrees. “Some believe any losses from FX risk are balanced out over the long term when currency fluctuations work in the company’s favour, but this means taking a significant risk with no reasonable expectation of gain, a strategy that isn’t sound business management,” he says.
Hedging instruments, available through financial institutions, typically require security of around 15 per cent, but EDC can work with your bank to provide a Foreign Exchange Facility Guarantee.
See also EDC TradeTalk
BOX: Basic FX risk management
While effective FX risk management is far from a trivial undertaking, especially at the setting-up stage, it’s well within the reach of any company that makes the effort. It requires these steps:
- Analyze your business’s operating cycle to identify where FX risk exists. This helps you determine the sensitivity of your profit margins to FX fluctuations and the stages of the operating cycle in which you need protection.
- Calculate your exposure to FX risk. Once you know your exposure, you can decide how much risk coverage you need.
- Hedge your FX risk. “Hedging” simply means that you use specially designed financial instruments to lock in the exchange rate.
- Create an FX policy and follow it. You establish the FX risk criteria, procedures and mechanisms that will underpin your FX risk management program, and implement this policy across the company.