Currency risk management will mitigate the negative effects of adverse movements in foreign exchange markets.
April 19, 2011
by Karl Schamotta
The world is getting smaller for many Canadian manufacturers. Supply chains are stretching around the world and companies are venturing farther afield, seeking opportunities in places that have long been the exclusive preserve of large multinationals. Of course, operating in this smaller, more integrated world means rapid shifts in the foreign exchange markets can have a significant impact on the bottom line.
The ultimate objective of a currency risk management strategy is to mitigate the negative effects on a company’s value from adverse foreign exchange movements. The idea is to make cash flows more predictable so strategic financial decisions are easier to make and growth is sustainable.
Take a step back from day-to-day trading and assess your operations from a strategic perspective. Start by identifying your long-term objectives. Writing a formal policy is often the most effective way to ensure that your trading framework matches your goals.
A simple and effective formalized policy can be created relatively quickly and easily, and modified over time as conditions change. Most risk policies are brief but cover the following areas:
• articulate the company’s risk tolerances and objectives;
• outline the process for measuring currency exposures;
• create responsibilities and internal controls for personnel;
• identify when and why financial hedges should be executed;
• specify which tools may be used to cover exposures; and
• implement an ongoing review and analysis process.
Building your strategy around this framework should help to ensure trades precisely match exposures, they’re placed for the right reasons and are the right tools for the job.
A manufacturer with an organization spread across the world has a range of currency exposures. Managing the risks requires open and clear communication, and everyone must be aware of the consequences associated with foreign exchange transactions. Ensuring that the disparate parts of your organization are keeping decision makers informed on a timely basis will reduce the possibility of dangerous surprises.
In many cases, effective communication turns a risk into an opportunity. Understanding implications of market movements and cross-currency transactions adds value to the negotiation stage, making your company far more competitive, particularly when bidding on projects or buying products internationally. Also, the longer the timeframe between incurring the exposure and the point at which funds must flow, the more opportunities will be available to execute trades at favourable levels.
There are two primary ways to protect your company from risk.
To reduce long-term risk, a natural hedge will match your revenues and expenses. This can involve building a production facility in a country where your revenues are generated, or denominating debt in a currency that mirrors your income stream. Paying salaries or bonuses in US dollars when revenues are earned in the US is also a common practice. Avoiding the need to buy or sell foreign currency not only reduces exposure, it eliminates significant transaction costs. Diversifying your operations often lowers long-term risk, while building a foundation for sustainable growth.
If natural hedging isn’t possible, companies will typically turn to shorter term, transactional tools.
The use of financial derivatives is the most common strategy employed by successful manufacturers. A broad variety of tools and strategies are available, from the simple to the highly complex.
Forward contracts enjoy the most widespread use, allowing companies to buy and sell foreign currencies today for settlement in the future. Forwards are highly efficient and extremely flexible, allowing you to easily specify settlement periods, amounts and delivery methods.
Tools such as swaps, structured options and non-deliverable forwards also provide protection against foreign exchange risk, helping to achieve business objectives such as redeploying capital globally, capturing upside potential when favourable moves are expected, and doing business in nations with protected currencies.
The only certainty in currency markets is that exchange rates will move, but in both directions on a daily basis so obtaining incremental gains is easily accomplished using specific tools and a disciplined approach.
Many global manufacturers achieve this by initially hedging less than 100% of their expected needs. Ensuring your margins are fully protected is vitally important if you wish to remain sustainable, but leaving part of your cash flow unhedged allows you to enter the market at a later date. Without taking a directional view, use tools such as limit orders or structured option products to increase protection over time.
Harness short-term volatility by seeking small gains rather than attempting to capitalize on large, long-term market shifts. Many small gains add up to more than one big move, and can be achieved with much less risk.
Canadian companies have access to some of the world’s most advanced financial machinery. Pair this with a robust currency strategy and you will out-compete international firms while dramatically improving domestic performance.
Karl Schamotta is a Calgary-based senior market strategist for Western Union Business Solutions (business.westernunion.ca). E-mail email@example.com or call (403) 827-9741.