In a previous article [1], we discussed the use of volatility as a measure of uncertainty, the factors that influence it, and the impact it can have on SMEs. In this new article, we explore currency risk for SMEs. from the angle of foreign exchange volatility during the budgeting process. Creating a budget when exporting and/or importing in one or more currencies can be a challenge.
Why Evaluating Currency Risk Matters
The variability in the value of budgeted sales or costs across different currencies leads to different impacts on cash flow—especially on available cash—and ultimately, on profit.
As part of the budgeting process, it’s crucial to compare transactions that will take place in various international markets to make the right decisions.
Comparing the Profitability of International Suppliers
For instance, at what price is a supplier in Mexico (pesos) more profitable than one in the U.S. (U.S. dollars)? To make them comparable, profitability and risk must be connected as early as the budgeting stage.
To achieve this, we need reference points on the level of uncertainty and risk associated with the transactions we’re planning in foreign markets.
Understanding Currency Volatility
So-called exotic currency pairs tend to be more volatile on the FX market, as they typically have lower liquidity [2] than major currency pairs [3] Countries like Turkey, Brazil, Russia, and Mexico have some of the most volatile currencies.
Major pairs are usually less volatile, although even these have shown heightened volatility since 2020.
Example: Mexican vs. U.S. Market
Take the Canadian dollar (CAD) against the U.S. dollar (USDCAD). With a historical volatility of 8.2%, the range of possible values can vary by more than 21 Canadian cents.
With an average exchange rate of 1.3000 USDCAD over the period, the statistical range would be between 1.1931 and 1.4069. Statistically, there is a 68% [4] probability that exchange rates will fall within this range.
Now consider the same exercise with the Mexican peso (MXN). With a volatility of 14.5% and an average rate of 0.0622, the expected trading range is 0.0532 to 0.0713—a spread of 1.8 Canadian cents.
This highlights the scale effect. While MXNCAD is more volatile (14.5%) than USDCAD (8.2%), the spread for USDCAD is much wider. It’s essential to understand this scale effect, as percentages can be misleading if misinterpreted.
Comparing Risk and Profitability
We must consider the base rate (0.0622 and 1.3000) these percentages are applied to. For illustration, we’ll use the same commercial transaction size: 1 million CAD [5].
A variation of 0.9 cents (1.8 ÷ 2) in a Mexican transaction can result in a gain or loss of 145,093 CAD (290,146 ÷ 2), whereas a variation of 10.7 cents (21.4 ÷ 2) in a U.S. transaction generates a gain or loss of 82,201 CAD (164,403 ÷ 2).
Consequences for SMEs
If the CAD moves by 1 cent against both the USD and MXN, the impacts are not the same. For the Mexican transaction, the change equals 160,659 CAD, while for the U.S. transaction, it’s only 7,692 CAD. A 1-cent move against the MXN is over 16%, whereas against the USD, it’s barely 1%.
So, for the same 1 million CAD transaction, the impact of a 1-cent movement on cash flow and commercial profitability will differ depending on the currency.
Evaluating Currency Risk and Integrating it into Budget Planning
This differential must be explicitly accounted for in budgeting. Not only will hedging needs differ, but so will the risk-reward profile. Clearly, earning $10 by risking $3 is preferable to earning $10 by risking $8.
And this is exactly the kind of decision facing Canadian SMEs operating across multiple markets. A 1 million CAD transaction in Mexico is not equivalent to a 1 million CAD transaction in the U.S. That’s where the risk/reward trade-off comes into play—right at the budgeting stage—to help make international transactions more comparable.
You’re now better equipped to compare the risks of your international operations on an equal footing. In the next article, we’ll look at how to integrate these risks into budget planning and link them to your strategic decisions.
[1] See the article Volatility and Inflation in a Context of Economic Growth
[2] See the article Currency Volatility: How to Account for it in Currency Risk Management
[3] See the article Currency Market: Essential Concepts
[4] Expected frequency of movements within 1X, 2X, and 3X the standard deviation is 68.3%, 95.5%, and 99.7% respectively.
5] The impact of a 1-cent CAD change on a transaction of 1 million MXN or USD is 10,000 CAD. To properly compare volatility, we use a base of 1 million CAD as the reference (functional) currency. The forecast range is based on annual volatility.
[6] Divided by 2 to reflect the ± side of average volatility (e.g. ±14.5%).
For more insights on currency risk for SMEs, see these related articles: Currency Risk for SMEs: Budgeting and Market Performance Comparison Tool, Currency Risk for SMEs: From Forward Contracts to Options and How to Manage Currency Risk When Selling Abroad.
International Markets: A World of Opportunities
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