Currency Hedging Strategy: Understanding Exchange Rate Risks
Foreign exchange risk is the risk that a company's financial position will be affected by fluctuations in exchange rates. This risk is especially present for companies that trade in more than one currency.
For example, those who sell in another country and the customer pays in their own currency, or those who purchase products and/or services in a currency other than the Canadian dollar.
The currency hedging strategy must be developed in such a way that the company remains focused on its primary mission, its commercial operations, without exposing it unduly to financial risks.
Different sources of exchange rate risk
Currency Hedging Strategy: Measuring Risks
There are many ways to measure currency risk, some more complex than others. Sophisticated measures, such as “value at risk (VaR)” can be data intensive, mathematically complex, but without providing much added value for the SME. We will look at some examples of simpler measures that can be easily applied and implemented by most SMEs.
Register of Foreign Coin Exhibitions
This method is very simple. It aims to maintain a record of exposures (trading transactions) and their associated foreign exchange hedging transactions (forward contract, option, etc.). Consequently, the details of each hedging transaction are recorded against the exposure it is intended to hedge. By applying the result of the hedging transaction to the realized value of the cash flow of the trading transaction, after conversion into Canadian dollars, the profitability of the latter is easily determined.
Anticipated Cash Flow Schedule
When the company pays and receives various currencies, it is necessary to measure the net surplus (or net deficit) that business operations generate in each of the currencies. This is done by projecting cash flows in foreign currencies. This forecast of the company's cash flows indicates not only whether the company has a surplus or is short of a currency, but also the estimated dates for which these cash flows are expected.
Sensitivity Analysis
In addition to the cash flow schedule, the company can undertake a sensitivity analysis to determine the potential impact on the profitability of business operations of an adverse movement in exchange rates. This can be done by choosing arbitrary exchange rate movements or based on fluctuations observed in the past. The company will then know by how much its commercial profitability is impacted for a given variation in the exchange rate. The company can then determine a threshold from which it is imperative to be hedged.
When materials such as oil, resin, wood, etc. are involved, companies often develop a matrix showing the combined result of currency and commodity price fluctuations in order to measure their level of risk.
Value at Risk (VaR)
Finally, a few words on VaR. This type of approach, which combines probability and sensitivity analysis, is mainly used by financial institutions. The analysis seeks to determine, in addition to the potential impact of a given variation in the Canadian currency (for example, a movement of 1 US cent), the frequency with which this movement may occur.
Very briefly, this involves performing a sensitivity analysis of the timing of cash flows based on historical exchange rates in order to obtain a statistical interpretation of the risk. Then, given the company's current position, and based on the exchange rates observed over, for example, the last two years, we seek to determine, for a given probability, that the company will not lose more than a certain amount, following a change in exchange rates. In short, the company has used the historical exchange rates to model the potential impact of exchange rate fluctuations on its current exposures.
Managing Exchange Rate Risks
After identifying and measuring the potential exposure, the next challenge is to manage it. There are many instruments for this, which will be discussed in a future article. However, it must be clear that the use of these instruments is not the management of foreign exchange risk as such; it is only a consequence of it.
In fact, at D-Risk FX, we believe that foreign exchange risk management consists of the processes upstream of the use of these instruments. Processes that make the company ready to control the potentially harmful effects of an unfavorable movement in exchange rates or, the strategic approach that makes it ready to also capitalize commercially on favorable currency movements without taking a speculative position. The primary objective always remains the commercial success of the company.
Pour plus d’information, voir les articles intitulés: Currency hedging strategy: choosing the right ratio.and Currency Hedging Strategy: Deciding to Hedge Factually
For detailed information on managing foreign exchange risk, please see the article titled: How to manage exchange rate risk?
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