4 questions to help understand currency risk


With the volatility of exchange rates in recent years, not having
a basic understanding of currency risk is risky, especially for
small businesses with limited liquidity.

Marie-Christine Daignault | Desjardins Group

While most entrepreneurs protect their assets against the unexpected, many forget to protect their ultimate goal: their profits. Given the volatility of the currency market in general, currency risk is a very real risk for companies that operate on international markets, and one that shouldn't be overlooked. To protect against it, you first have to understand what it is.

For all companies that operate on international markets.

1. What is currency transaction risk?
Currency risk involves the foreign currency payables or receivables generated as a result of contracts a company has signed (or subsequently signs). It's the risk that the currency will fluctuate in a way that hurts the company in that it will have to convert foreign currency under less favourable terms than originally budgeted. This risk affects both importers and exporters.

2. Why protect yourself?
With the volatility of exchange rates in recent years, not having a basic understanding of currency risk is risky, especially for small businesses with limited liquidity.
Advantages of hedging: 
  • Eliminates the uncertainty of fluctuating exchange rates 
  • Facilitates the implementation of budget planning 
  • Protects the cost or profit structure 
  • Allows companies to focus on their core activities
3. What protection is out there?
There are products that are specifically designed to reduce or even eliminate the risk posed by foreign currency fluctuations, thereby making it easier for businesses to get through highly volatile periods.

Forwards 
A forward contract is an agreement between two parties to buy or sell an amount at a predetermined rate and date. When the contract expires, the conversion rate will be the contract rate, regardless of the market rate. Forward contracts thereby allow companies to protect themselves from unfavourable currency movements. 

Currency swaps 
Currency swaps are a cash flow management tool that is very popular with businesses that have foreign currency inflows and outflows at different or unexpected dates. It involves two opposite transactions that are done simultaneously for the same notional amount. Currency swaps are used for:
  • Matching cash flows 
  • Moving up or extending a forward 
  • Financing 
Vanilla option 
The vanilla option, also known as the traditional option, allows buyers (companies) to buy or sell a foreign currency amount at a predetermined date and rate. The option seller (financial institution) is obliged to buy from or sell to the option buyer if the buyer exercises the option.

The company thereby guarantees a floor or cap rate, while providing an opportunity to capitalize on favourable currency movements. To obtain this right, the option buyer pays a premium to its financial institution.

Option strategies 
The disadvantage of vanilla options is the premium paid when buying the option, which can be fairly high depending on the level of protection desired.

Thankfully, by combining the purchase and sale of an option, it's possible to create option strategies that do not involve premiums. Option strategies with no disbursement give you protection from unfavourable currency movements, while letting you take advantage of favourable ones. There are a variety of option strategies that can be adapted depending on your needs.

4. How can I establish a currency exchange policy?
Once you become more familiar with currency risk and certain hedging instruments, you'll undoubtedly see the need to establish a currency exchange policy so as to adequately manage the risk.

Define your needs 
  • What percentage of my accounts payable and receivable is in foreign currency?
  • What is my tolerance for exchange rate fluctuation? At what point is my company's profitability in jeopardy? 
  • Can I match the expiry dates with payable and receivable amounts when they're denominated in the same currency?
  • Can I bill clients for losses incurred due to exchange rate fluctuation by raising my prices?
  • Do I intend on making major foreign investments in the near future? 

Choose the right hedging strategy

  • No hedging - spot transactions only 
  • Systematic and complete hedging 
  • Selective and partial hedging 
  • Natural hedging
Know your options 
Selecting the hedging instrument that's right for your situation is the best way to protect your company against the risks of exchange rate fluctuations. Knowing and understanding the products available will help you decide which instrument or instruments are right for you.

Revise your hedging strategy as needed 
The final step is to implement your strategy. Since managing currency risk is a dynamic process, you should keep a close eye on changes to your needs and market conditions, and then adjust as needed. 

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