In a previous article [1], il était question d‘identifier et de mesurer le risque de change afin qu’il soit géré de manière à ce que l’entreprise reste concentrée sur sa mission première, ses opérations commerciales, sans l’exposer outre mesure à des risques financiers.
Understanding Hedging Instruments for Currency Risk in SMEs
Certain financial instruments can be used to mitigate currency risk for SMEs.. However, before using them, the company must determine the risk appetite of its main shareholders and executives, and establish a rigorous decision-making framework. In fact, the absence of a proper risk management policy—aligned with the company’s overall strategy—can leave the business vulnerable to negative financial outcomes.
Key Factors to Consider in Currency Risk Hedging for SMEs
The Trade-Off
The decision to hedge (or not) involves a trade-off between uncertainty and opportunity cost. For example, by using a financial instrument, the company locks in a specific exchange rate in advance, thereby eliminating uncertainty. However, this also means the company cannot benefit from a favorable shift in exchange rates—certainty comes at the cost of opportunity.
Forward Contracts
A forward contract is a financial instrument that allows a company to lock in a specific exchange rate for a future date. These are custom-made, over-the-counter (OTC) agreements negotiated directly with financial institutions. They are unregulated and traded on the interbank market.
How Forward Contracts Work
The company commits (and is obligated) today to buy (or sell) a specified amount of currency A in exchange for currency B at a specific future date. The forward contract allows the company to protect itself from adverse exchange rate movements by locking in a fixed rate for a defined period.
As a result, the company is protected and knows its exchange rate with certainty. However, it cannot benefit from a favorable market movement, as it must fulfill the contract regardless of whether the exchange rate moves in its favor.
Example: Protecting a USD Sale with a Forward Contract
A Canadian company sells a product today (June 26) for 100,000 USD and expects to receive payment in two months. On June 26, the forward exchange rate for August 26 is 1.32. The company enters into a forward contract at this rate with its financial institution.
Visual Illustration of a Forward Contract
Assumption: Forward exchange rate is 1.32
The value of the USD sale in CAD is fixed as soon as the forward contract is signed (100,000 USD × 1.32 = 132,000 CAD), even if the USD payment is received two months later. There is no longer any uncertainty regarding the value of the sale once converted to CAD—at the cost of missing out if the rate turns out to be higher than 1.32 at maturity. Exchange rate fluctuations no longer impact the profitability of this transaction.
Currency Options [2]
There are many types and variations of currency options available on the market, but they generally share the following characteristics. An option:
Distinction between a call option and a put option:
Example: Protecting a USD Sale with a Currency Option
(Same scenario as the forward contract example)
The company enters into a put option on the US dollar today, with a strike price of 1.32 and an expiration date of August 26, and pays a premium of 2,000 CAD.
Visual Illustration of a Currency Option
Assumption: Strike price of 1.32
The option gives the company the right—but not the obligation—to sell the USD it expects to receive in two months at a fixed exchange rate. If the company exercises this right, the counterparty is obliged to purchase the USD at the strike price.
The company now knows the minimum rate (floor) at which it can convert its USD to CAD. The minimum value of its USD sale is fixed (130,000 CAD), calculated as the strike price minus the option premium (2,000 CAD for the sake of this example). The company pays the premium [3] to guarantee a minimum rate while retaining the potential benefit of favorable currency movements.
The Currency Collar
A combination of a put and a call option with different strike prices on the US dollar creates what’s called a collar. When the premium paid for the put equals the premium received from selling the call, it becomes a zero-cost collar
How a Collar Works
The strike prices determine the collar’s boundaries. For instance, buying a put with a strike price of 1.29 can be financed by selling a call with a strike price of 1.35. If the CAD appreciates below 1.29, losses on the USD sale are offset by gains on the put option. If the CAD depreciates above 1.35, gains on the USD sale are offset by the cost of the call option.
The company now knows both the floor (1.29) and the ceiling (1.35) for the exchange rate. The minimum value of its USD sale in CAD will be 129,000 CAD, and the maximum will be 135,000 CAD—locked in as soon as the collar is executed.
Effectively, the company trades a higher ceiling than the forward contract rate in exchange for a lower floor. The collar limits exposure to unfavorable movements (from 1.32 to 1.29) while allowing gains within a certain favorable range (from 1.32 to 1.35).
In summary, a collar is a commitment to transact a fixed amount within a known price range over a defined period.
The table below highlights the key differences between the two major categories of hedging instruments for currency risk.
Using these instruments is most valuable when done within a clear and well-aligned framework that supports the company’s strategic goals. Having the right combination of expertise, data, tools, and well-defined processes ensures that the business gains the full benefit of currency risk management.
The support provided by D-Risk FX brings both expertise and structure, helping SMEs establish solid and profitable guidelines for managing currency risk. This enables the company to not only shield itself from adverse movements but also capitalize commercially on favorable currency shifts.
[1] Currency Hedging Strategy: Identifying Currency Risk
[2] Many types and variations of currency options exist in the market.
[3] The premium can vary depending on duration, strike price, and currency volatility.
Pour plus d’information sur le risque de change pour PME, veuillez consulter les articles : Currency Risk for SMEs: Budgeting and Market Performance Comparison Tool, Currency Risk for SMEs - Plan for Recovery with an Effective Policy and this guide published by EDC.
International Markets: A World of Opportunities
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