Currency Hedging Strategy: Determine the Right Hedge Ratio for Your Business
Your way of doing things within your company, with regard to the development of your currency hedging strategy begins with a verbalization of your attitude toward risk. Here are two questions with which to begin your reflection.
Currency Hedging Strategy: Risk Reduction Objective
Is your goal consistently to reduce your risk to 0?
Is your goal to systematically try to have a better exchange rate, i.e. do you prefer to maximize opportunities, even if it means paying in the event of an adverse move?
Between these two extremes, a more comfortable position for your company can be determined. In short, the real question is rather: do you want, to varying degrees, to take advantage of favorable exchange rate movements to generate profits and thus inflate your profit margin? The key, or the most important point in the answer is "to varying degrees". The more you want to take advantage of a favorable exchange rate movement, the more exposed you will be in the event of an adverse movement.
What is Coverage Ratio?
The hedge ratio is a measure of how much of your foreign exchange exposure you choose to hedge. Determining the optimal ratio depends on your company's risk tolerance.
Risk Tolerance
Your strategic goals should be aligned with your company’s risk tolerance. The more aggressive your goals, the higher your tolerance for accepting risk should be. Your risk tolerance will guide you to the right “degree” for your company.
Factors to Consider
Tolerance is a functional relationship between your company’s financial capacity to take risks and your willingness to take them. There is no right or wrong answer, there is your answer.
Factors to consider when determining your tolerance for risk, whether currency or any other risk, are:
- The level of control you have.
- The impact or consequence on your business.
- The probability that this risk will materialize.
- Experience and expertise or in other words, the time you can devote to it and the resources that are easily accessible to you in managing this risk.
For example, positive experiences and sustained effectiveness in managing a risk make it possible to confidently consider taking that risk. The availability of capital can make it easier to absorb a loss without putting your company’s overall performance at too great a risk. The availability of real-time data and its transformation into information for decision-making, as well as employee skills, are important factors that influence “the degree” to which you want to expose your profit margins.
Exchange Rate Movements
Exchange rate movements are rather unpredictable, they behave like random variables: no control can be expected over this variable. The possible impact on your company can be measured using the concept of risk scope. [1]. On average over a month, since 1991, the USDCAD has fluctuated by 4 cents or 40,000 CAD per million of monthly turnover in the United States [2]; it is therefore very likely that a monthly movement of this magnitude could materialize.
Volatility can also be used as a measure of uncertainty. [3]. The Canadian dollar (CAD), for example, against the US dollar (USDCAD) is estimated to have a historical annual volatility of +/- 8.2% around its mean and, therefore, has an annual range of possible values of plus 21 Canadian cents.[4]. The resources and time you have to manage this risk should be the basis of the “degree” to which you are willing to expose your margins because currencies move quickly and frequently and often with large amplitudes. The company cannot afford to be reactive, it must be prepared.
Risk Preparation and Management
Currencies move quickly and frequently with large amplitudes. The company cannot afford to be reactive; it must be prepared. Do you have tools that allow you to synthesize and update all the relevant information in one place? This gives you a clear view of the sources of variability in your performance and better control over the “degree” of variability to which your margins are exposed.
It is crucial to understand and define the amount of risk your business is able to take and to be able to define the risk it is willing to tolerate to ultimately determine the amount of risk it is willing to take.
Key Questions for Determining Coverage Ratio
To do this, three useful questions, the answers to which are specific to each company.
- What is your capacity to handle a loss? Your source of income and its consistency as well as your other sources of liquidity are the basis of your capacity.
- What is your willingness to tolerate risk? This is a more emotional aspect. Think about the last time you handled a loss: how did you react? What is that threshold amount that you are not willing to exceed to achieve your goals, no matter how capable you are?
- What do you have to gain by accepting this risk? Or put another way, what are you willing to lose for the chance to win $1?
In risk management, the only wrong answer is your neighbor's!
(1) See article « Currency Volatility: Understanding the Scope of Exchange Rate Risk »
(2) That’s more than 25% of your profits that are at risk if, for example, your business makes a profit of CAD 150,000 per million in monthly sales (CAD 40,000 / CAD 150,000)
(3) See the article “ Currency Volatility: How to Account for It in Currency Risk Management?»
(4) See the article “ Currency risk for SMEs; How to assess hidden budget risks ? »
For more information, please see the articles " Currency hedging strategy: choosing the right hedging ratio " And " Currency Hedging Strategy: Navigating Market Uncertainty ".
For additional information on currency hedging strategies and best practices, see the Bank of Canada Guide to Financial Risk Management.
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