Manage FX Risk: Protect Your Profits From Currency Swings

The possible decline of a company’s cash flow and profits owing to currency fluctuations is known as foreign exchange (FX) risk.

FX risk poses a challenge for all exporting companies, regardless of size or international experience, especially in today’s tough business environment. Here’s what you can do to better protect your export earnings and profits.

FX Analysis

The Canadian dollar’s value fluctuates daily on foreign exchange markets. This volatility makes it difficult for exporters to set prices and predict future cash flows. Harder still, it can cut into your revenues and profits.

Two-thirds of Canadian exporters, who participated in an EDC survey on FX risk, believe they should improve the way they manage this type of risk. A key step in this direction is to develop an FX policy – written goals and guidelines that provide direction to company members who manage FX risk. It helps eliminate the guesswork and makes it easier to evaluate your performance in reducing the negative impact of currency movements.

In reality, fewer than one out of five Canadian exporters report having an FX policy. Yet those who do are more likely to successfully manage FX risk. “I have worked with many companies that were dealing with FX risk in an ad hoc manner – without knowing exactly when their FX exposure arose, how much FX exposure they had and without any clear guidelines as to how to hedge this exposure. Because of this, many did not know the amount of money they were gaining or losing due to changes in exchange rates,” says Normand Faubert, a consultant specialized in assisting companies manage FX risk.

“Many firms rely on their financial statements to evaluate the impact of currency volatility on their bottom line. This is a mistake, since accounting gains and losses due to FX are not meant to calculate the full impact of exchange rate changes on profits and cash flow,” adds Faubert. “Preparing an FX policy and a system to track FX exposure and true FX gains and losses can consume some time up front. In my experience, it is an investment that pays itself back very fast through increased profitability and competitiveness.”

FX Position in USD

Developing an FX policy

You can craft a basic FX policy by identifying and applying four key parameters.

Cover all Four Angles

Many exporters go straight to a hedging strategy and neglect the first three parameters of FX risk management, described in this article. As a result, you may use the wrong reference rate or develop a hedging strategy based on an inaccurate measurement of your FX position.

1: Reference rate of exchange

This is the exchange rate you use when setting export prices. This rate should reflect the market exchange rate on the day you establish your selling price in a foreign currency. Suppose that today you set your export price in U.S. dollars on a product that must return CAD 100. If the USD/CAD exchange rate is 1.0525, this becomes your reference rate and your export price would be USD 95 per unit (see FX Analysis table, above).

Knowing your reference rate lets you calculate precisely how much you gained or lost due to changes in the loonie’s value.

2: Time horizon

This is the period during which your company does not change its reference rate and commits to an export selling price. For example, if you issue price lists to foreign buyers that are valid for a year, then your time horizon is one year. Knowing this time frame helps you calculate your “unconfirmed” FX risk – your expected export sales for that year at prices calculated using the reference rate. So, if you estimate you will export 150,000 units during the coming year, based on past performance, then your unconfirmed FX risk is USD 14.25 million (USD 95.00 x 150,000 units).

“Exporters are exposed to FX risk the minute they set their reference rate,” observes Faubert. “Many companies, and not necessarily the smallest ones either, start to focus on their FX exposure only once a sale is confirmed and an accounts receivable created at that day’s exchange rate. Yet, the price for the goods and services that have just been sold may have been set months ago when the exchange rate was quite different!”

3: FX position

This is your company’s total exposure to FX risk (see FX Position chart, opposite page). You should be able to calculate it every day. The FX position is made up of unconfirmed FX risk as well as “confirmed” risk, representing actual sales orders, accounts receivable and cash. You would also deduct orders and amounts payable in the same foreign currency (USD in this case). If your company has already purchased FX hedging instruments from your bank or FX broker, these are included in the FX position, since they help reduce your exposure.

4: FX hedging strategy

This involves three key steps. First of all, choose a hedging ratio – the percentage of FX coverage you put in place compared to your FX position. A 100 per cent ratio means that your FX position is completely covered. Many exporters have a hedging ratio below 100 per cent. This is perfectly acceptable, as long as you are capable of withstanding FX losses that may occur because your exposure is not fully covered.

Second, select your FX hedging instruments. There are two main types: FX forward contracts and FX options. Forward contracts allow you to buy or sell a given amount of foreign currency in the future, at a set rate. FX options give you the right, but not the obligation, to do so. Each instrument has unique advantages that your banker or FX broker can describe in detail. When purchasing such instruments, your bank or broker may ask for collateral; this requirement can be met with EDC’s FX facility guarantee program (FXG) to free up your cash.

Finally, decide when to hedge your FX exposure. Systematic hedging consists of covering your exposure as soon as it arises. Progressive hedging means you wait until the exchange rate reaches a certain level (either up or down) before purchasing FX hedging instruments. With progressive hedging, you accept a certain amount of risk in the hope of benefiting if the exchange rate moves in your favour. But, once again, make sure you can tolerate any FX losses that can occur. Systematic and progressive hedging can be used together.

Want to learn more? See Building a Foreign Exchange Policy at edc.ca.

Jean-François Lamoureux, senior advisor, EDC Corporate Research Department, is a frequent speaker on currency and hedging issues.

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