Factors in a Properly Constituted Foreign Exchange Program
Mike Smith is one of the best known Foreign Exchange experts in Canada. He sold his brokerage to a U.S. firm that operates in Toronto. After his non-competition agreement expired, he set up Maryknollfx.
Smith believes that for every action there is a reaction and for Canadian business dealing in foreign markets this relationship has never been more dangerous. On the one hand you have an opportunity to grow your business as with the new CETA trade agreement with Europe but then you have the new Trump administration issuing new trade tariffs and renegotiating the NAFTA trade agreement. On top of this you have currency volatility that can take away any profitability you create, the question arises as to how does a business protect their profits when they look to expand beyond our border?
Smith comments that the most successful way to navigate foreign markets and understand currency movement is to create a hedging program that is suited for your business. Make no mistake, large or small if you are doing business outside of Canada not only do you need to understand trade and custom laws but you must have a hedging program in place to ensure the timing of your FX transactions is optimal.
Factors that all hedging programs should have in place:
1. Risk-based Approach
As a business owner, CFO or controller if you are dealing in foreign currencies you need to have not only a view on the value of the currencies you are dealing with but also have an understanding on how much volatility in a currency you want to risk. A hedging program that wants all currency risk removed will hedge 100% of their exposure at the time the risk is created (i.e. foreign sale is made or foreign purchase order is completed). Businesses that tend to be use successful programs will have a plan in place that will hedge a good portion of their risk at inception but then use the market to improve their profitability by employing certain products and practises.
Proper communication is essential to a strong hedging program. Business leaders must be given timely information on moves in the FX markets so as to make better decisions. This communication can run the gamut from nothing more than a daily email in the morning to update the markets or a financial department watching currency charts during the day to monitor all movement. Currency alerts are a great tool that should be part of your program, emails or phone calls from either your bank or third-party FX provider must arrive in a timely fashion so that you can take advantage of positive currency moves or be made aware of moves that could damage your profitability.
3. Hedging Products
Any strong program should have a mixture of the following products:
Spot Trades: these are simple FX trades that are done on a daily basis as dictated by your cash flow, exchanging one currency for another at an agreed upon rate. In a program that is not 100% hedged you should only be using spot trades on a limited basis as they may be at unfavourable rates.
FX Forwards: are the most popular hedging tool and are generally entered into when your currency risk is created. Simply put they are spot trades that lock in your rate at the time of the transaction but can be settled at a point in the future when your cash flow needs to use them. You are fully protected against adverse currency moves but you do not participate if the currency goes in your favour.
Order Management: this is perhaps the most effective tool for any proper hedging program and the one thing I would say to start using if your business does not employ any hedging program. Just like the stock market, you can leave an order with your bank or third-party FX provider to purchase a currency at a particular level and if the market hits your level you can then enter into a Spot or Forward trade to arrange settlement. This practice allows a hedging program to improve its overall average rate at the same time increasing the amount hedged in the portfolio. The risk of course is that the market moves away from your orders and the rates are not filled, if you have stayed within the risk profile you created then your business will be able to handle this situation.
Currency Options: are nothing more than paying a premium for insurance against adverse currency moves that also let you participate in the upside of a favourable currency move. There are a myriad of options strategies that could be considered but if you do want to look at adding options to your program make sure they are fully explained to you and you understand the obligations that come with them.
Examples of recent hedging programs
Steel Distributor: In purchasing large amounts of speciality steel (in US Dollars) around the globe this company needed to protect themselves over the past few years from a rising US Dollar. The Company took the view that the Greenback would continue to rise so they hedged 75% of their monthly exposure using option dated forward contracts and then placed orders to pick-up U.S. dollars on a spot basis anytime the US Dollar fell in value. At the end of the year the company had saved hundreds of thousands of dollars and was able to delay price increases to its customers.
Pharmaceutical Company: in selling a great deal of its services into the US this particular company was in an unenviable position of seeing its revenue grow in tandem with a weakening Canadian dollar. The company decided that with a three month lead time from product sale to incoming cash flow it would be happy with hedging 50% of its flow and then using a combination of currency options and spot orders to take advantage of the U.S. dollar getting stronger.
Livestock producer: this was a particularly interesting case and shows just how flexible a hedging program can be. This producer is in a very volatile market with prices for its products changing almost hourly. With the company selling into the U.S. it was decided that they would update their sales force with a new reference rate every day and then fully hedge their average daily sales each day on a rolling forward basis going out three months at a time. This practise increased their profitability and better managed their cash flow.
Smith wrapped up by saying “Big or small if you are doing business outside of Canada stop and have a look at how you are doing your business, it could be a simple as asking someone to update on currency moves or as big as building a complete intensive program, make sure you review your transactions to ensure you are getting as much value as possible out of them.”
Mark Borkowski is president of Mercantile Mergers & Acquisitions Corp., a mid-market M&A brokerage.