Developing Your Currency Hedging Strategy
In the previous article [1we discussed the importance of clearly defining your approach to foreign exchange risk and using risk tolerance as a guide to determine an appropriate "degree" of exposure for your business. The hedge ratio is the practical expression of this "degree" of exposure. Therefore, when developing your currency hedging strategy, it is crucial to properly set the hedge ratio to better control margin variability.
Currency Hedging Strategy and Your Company's Budget
First and foremost, it is not about predicting exchange rates but rather anticipating your company's performance. Risk is managed on a Remaining to Be Done (RTBD) basis; it can be analyzed with past data, but it is managed in the future
Budget Rate
Foreign exchange risk management begins with a budget rate [2], which is set at the beginning of the budgeting process. This rate serves as a benchmark indicator, marking the company's risk exposure. Based on this budget rate, upcoming currency-denominated expenses and revenues are estimated and integrated into the budget plan. These forecasts form the basis for measuring the company's exposure and calculating budgeted margins (targets).
Effectively linking foreign exchange risk management to the budgeting process is essential. As soon as the budget preparation begins, the company must ensure it understands its risk by establishing its currency position.
Tolerable Deviation, Threshold, and Budget Sensitivity
Next, determine how sensitive your budgeted margins are to exchange rate fluctuations. Are you comfortable with margin variations caused by exchange rate movements?
Then, based on your risk tolerance, estimate the unfavorable deviation you are willing to accept around your budgeted margin. What level of loss are you willing to tolerate in the event of adverse exchange rate movements to benefit from potential favorable rate movements?
Determining the Threshold and Minimum Acceptable Margin
If you want zero deviation, you will need to fully hedge your currency position at the budget rate—a costly and rarely optimal choice.
Based on the acceptable budget deviation and margin sensitivity, it becomes possible to infer the exchange rate corresponding to your minimum acceptable margin (your threshold exchange rate). Any movement beyond this threshold rate would result in a loss greater than your risk tolerance. For example, let’s assume an acceptable budget deviation of 500,000 CAD, representing 7.6% of your budgeted margin.
Without hedging, an adverse movement of 6.7 cents (1.3000 – 1.2332) reduces your expected budget margin by 500,000 CAD.
Now that your threshold and minimum margin are known (6,615,250 – 500,000 = 6,115,250 CAD), we proceed to calculate your budget sensitivity indicator.
A 1% appreciation of the CAD results in a budget deviation of 97,337 CAD, or for a 1-cent CAD movement, the deviation amounts to 74,875 CAD (6,690,125 – 6,615,250 = 74,875 CAD).
During the budgeting process, the company knows its threshold, sensitivity, and target margin, enabling it to address the following three scenarios effectively: 
1- Any forward exchange rate above the budget rate will secure a favorable budget variance.
2- Any forward exchange rate above the threshold will limit margin reduction within the acceptable variance.
3- Any forward exchange rate below the threshold will result in an unfavorable budget variance exceeding the tolerable limit.
The Role of the Hedge Ratio
The hedge ratio's role is to delay reaching the 1.2332 CAD per USD threshold by reducing the sensitivity of budgeted margins to exchange rate fluctuations.
The thinner the margins, the longer the operating cycle, and the more volatile the budgeted currency, the higher the hedge ratio should be.
By using a forward contract, the company determines today the exchange rate at which it will trade a portion of its USD position later in the year. As a result, part of the sales will be conducted at the forward rate, while the remainder will be at the prevailing rate when the company receives the sales proceeds. It is this effective rate that must be simulated and compared to the threshold to determine the comfort zone and the associated hedge ratio.
Choosing the Hedge Ratio
In our example, if the company secures a one-month forward rate of 1.29 for 75% of its USD position [3], the daily spot rate for that month could drop as low as 1.0629 [4] before exceeding the tolerable deviation.
This represents a movement of nearly 24 cents CAD or 18% relative to the budget rate.
For a hedge ratio of 25%, the daily spot rate would need to be 1.2143, approximately 8.5 cents CAD or 7%.
In this case, a 75% hedge ratio, at least for the initial months of the budget, may seem excessive. An 18% short-term movement is always possible but statistically unlikely. However, it could be suitable for a company with low risk tolerance, narrow margins, a particularly long operating cycle, and highly volatile currency exposure.
When a company is said to be over- or under-hedged, the reference is the distance between the required daily spot rate (1.0629) and the budget rate (1.30) for the effective rate to reach the threshold (1.2332 = effective rate).
There is no strict mathematical rule for the ideal distance—only the one with which you are comfortable. Being "over-hedged" results in costs due to excessive use of financial instruments and may limit credit facilities, while being "under-hedged" exposes the company to risks misaligned with its operational needs.
Optimizing Your Currency Hedging Strategy with D-Risk FX
D-Risk FX simplifies the development of your currency hedging strategy by integrating it into your budgeting process and providing real-time monitoring.
Forward-looking analysis should be prioritized over simple "reporting" to enhance profitability and manage foreign exchange risk. While risk can be analyzed using past data, it is managed in the future based on the company’s Remaining to Be Done (RTBD).
By linking your margin performance to exchange rates from the budgeting stage, D-Risk FX enables proactive decision-making to protect profits and limit losses, ensuring that your financial goals are met.
[1] See: Currency Hedging Strategy: Is a 70% Hedging Ratio Too High or Not Enough?
[2] Typically, a rate between the spot and the 1-year forward rate
[3] (75% x USD Position) / USD Sales = Equivalent hedge ratio on sales (64.14%)
[4] (1,29 x 75%) + (1,0629 x 25%) = 1,2332
For more details, see the article: Currency Hedging Strategy: Identifying Currency Risks
For additional information on currency hedging strategies and best practices, refer to the Bank of Canada Guide to Financial Risk Management.
International Markets: A World of Opportunities
Developing business abroad is a source of growth but carries risks for SMEs. The risk of currency fluctuations is one of the significant factors of success or failure internationally because it can quickly become complex to monitor the successive impacts of exchange rates on the anticipated performance of the company in order to support its profitability.
With D-Risk FX track the performance of each market and business line continuously while considering your hedging strategies.
Approach these markets with the security of a clear exchange rate risk management strategy and monitoring that matches your ambitions.