In our second article on volatility [1] , we explored currency risk for SMEs.. We focused on ways to compare various international transactions on an equivalent basis, taking into account how currencies differently impact profitability. However, integrating volatility as an indicator of uncertainty into the budgeting process to support decision-making can be a real challenge.
Importance of Budget Planning
Your budget is your tool for planning revenue, expenses, and tracking your goals. But how much variability around those goals is acceptable? Your budget is a control mechanism—a reference point for performance. Using a "budget exchange rate" per currency allows you to define your objectives: any deviation from the budget rate will result in a variance—favorable or not.
Identifying Foreign Costs and Sales
The first step is to identify all foreign costs and/or revenues likely to contribute to exchange rate variances and quantify them at the budget rate. Then, you need to make those exposures comparable. This means linking profitability and risk from the very beginning of the budgeting process. Clearly identifying the sources of risk and deciding—based on the company’s strategy—which ones are acceptable (according to your risk tolerance) and which should be mitigated.
As shown in a previous example [2], for the same transaction size and anticipated profitability in the reference currency, a transaction in Mexico presents a potential variation 1.76 times higher than a similar transaction in the U.S. (112% vs. 63%).
One transaction is clearly more uncertain than the other. Therefore, applying a uniform 70% hedge ratio across all company transactions may not be appropriate.
Comparing Transactions
Using the same hedge ratio implies that the company accepts nearly twice as much risk per CAD million of transaction in Mexico (CAD 43,528) than in the U.S. (CAD 24,660) after hedging.
It’s the interplay of the anticipated price paid (import) or received (export), the resulting profitability differential, and the hedge coverage that enables effective comparison and strategic choices. In our example, both transactions generate an expected profit of CAD 130,000.
To reduce the higher risk in Mexico, the company could consider raising prices [3] or increasing hedging on the Mexican exposure—unless the company made a deliberate choice to accept almost double the risk in that market.
Assessing Potential Variances
At the start of the budget planning process, you should estimate the maximum potential variance across the company and then allocate it by foreign market. Does it represent 10% or 50% of your anticipated profit?
In our example, each transaction yields CAD 130,000 in expected profit. One shows a potential variance of CAD 82,201 and the other CAD 145,093. That’s a total potential variance of CAD 227,294 against an expected profit of CAD 260,000. In other words, 87% of anticipated profit could be at risk: 68% from the U.S. market and 112% from the Mexican market.
Risk Tolerance and Budget Planning
Is this 87% variance within the company’s risk tolerance? More importantly, how much of this risk is acceptable, and how much needs to be hedged? And in which markets?
During the budgeting process, building a table that explicitly presents the budget-induced risk for each currency used offers a far better view of the risks and supports better decision-making. It becomes a simple and clear decision-making tool.
Using Volatility Data
Knowing that USD has a volatility of 8.2% and MXN of 14.5% is incomplete information. It does not express the amount of risk—in functional currency—relative to the expected profitability of each market for equivalent transactions.
Using the range derived from volatility (standard deviation) and the value of a one-cent CAD change on a typical CAD 1 million transaction makes it possible to compare the real impact of currency risk on business performance. Ultimately, it provides much better support for your decision-making process.
In summary, integrating currency volatility into your budget planning helps SMEs better understand and manage the risks tied to international markets. A market performance comparison tool allows your business to make better decisions, optimize profitability, and stay aligned with your risk tolerance.
[1] See: Currency Risk for SMEs: How to Assess Hidden Budget Risks?
[2] A one-cent CAD move on a CAD 1 million equivalent transaction in either MXN or USD represents a CAD 10,000 impact. To compare volatility accurately, we use a reference-currency basis (functional currency), in this case, CAD. The projected ranges are based on annual volatility.
[3] Pricing—when market competition allows—is your first line of defense.
For more information on managing currency risk for SMEs, check out: Currency Risk for SMEs: Harness the Power of Simulation, Currency Risk for SMEs: From Forward Contracts to Options and this article from BDC.
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