Your company’s currency risk management approach begins with verbalizing your attitude toward risk [1]. Here are 2 questions to start your reflection with:
Is your goal consistently to reduce your risk to 0?
Is your objective to systematically try to get a better exchange rate, i.e. do you prefer to maximize the opportunities, even if it means paying for an adverse move?
A more comfortable position for your company can be determined between these two extremes. In short, the real question is: do you want, to varying degrees, to take advantage of favorable exchange rate movements to reap profits and thus inflate your profit margin? The key or the most critical point in the answer is “to varying degrees.” The more you want to take advantage of a favorable currency movement, the more exposed you will be in case of an adverse movement.
But what is meant by varying degrees? Or in other words, what should your coverage ratio be?
Risk tolerance
Your strategic goals should be aligned with your company’s risk tolerance. The more aggressive your goals, the higher your tolerance to accept risk should be. Your risk tolerance will guide you to the right “degree” for your business.
Tolerance is a functional relationship between your company’s financial ability to take risks and your willingness to take them. There is no right or wrong answer, there is your answer.
Factors to consider when determining your risk-taking tolerance, whether in terms of currencies, or any other risk, are:
(1) The level of control you have,
(2) the impact or consequence on your business,
(3) the likelihood that this risk will materialize
(4) experience and expertise or in other words, the time you can devote to it and the resources that are easily accessible to you in managing this risk..
For example, positive experiences and sustained effectiveness in managing a risk make it possible to confidently consider taking that risk. The availability of capital can make it easier to absorb a loss without putting your company’s overall performance at risk. The availability of real-time data and its transformation into information to make decisions and the skills of employees are important factors that influence “the degree” to which you want to expose your profit margins.
Tolerance and currency risk
Exchange rate movements are rather unpredictable, they behave like random variables: no control is to be expected on this variable. The potential impact on your company can be measured using the concept of risk extent [2]. On average over one month, since 1991, USDCAD has fluctuated by 4 cents or CAD 40,000 per million monthly turnovers in the United States; it is therefore very likely that a monthly movement of this magnitude can [3] materialize.
Volatility can also be used [4] as a measure of uncertainty. It is estimated that the Canadian dollar (CAD), for example, against the US dollar (USDCAD) has a historical annual volatility of +/- 8.2% around its average and, therefore, has an annual range of possible values of more than 21 Canadian cents. In short, currency risk always ends up [5] materializing, no matter how you measure it.
The resources and time you have to manage this risk must be the basis of the “degree” to which you want to expose your margins because currencies move quickly and frequently and often with high amplitudes. The company cannot afford to be reactive; it must be prepared.
For example, do you have at your disposal tools that allow you to synthesize and update all the relevant information in one place to give you a clear vision of the sources of the variability of your performance over your rest to do and, therefore, better control over the “degree” of variability to which your margins are exposed?
It is crucial to fully understand and define the amount of risk your company is able to take and, also, to be able to define the risk it wants to tolerate to ultimately determine the amount of risk it wants to take.
To do this, three useful questions, the answers to which are specific to each company.
(1) What is your ability to manage a loss? The source of your income and its consistency as well as your other sources of liquidity are the basis of your capacity.
(2) What is your willingness to tolerate risk? It’s a more emotional aspect. Think about the last time you dealt with a loss: how did you react? What is this limit amount that you are not willing to exceed to achieve your goals regardless of your ability?
(3) What do you gain by accepting this risk? Or put another way, what are you willing to lose to have the opportunity to win $1
In risk management, the only wrong answer is that of your neighbor!
Follow us on LinkedIn, in a future article, the concept of tolerance will be incorporated into the construction of your budget to validate your choice of coverage ratio.
[1] See the article “False Dilemma”
[2] See the article “What is meant by the extent of risk?”
[3] More than 25% of your profits are at risk if, for example, your company makes a profit of CAD 150,000 per million monthly turnovers (CAD 40,000 / CAD 150,000)
[4] See the article “Currency risk: How to take volatility into account in your management?”
[5] See the article “Two markets, one measure? How to assess the hidden currency risk in the budget? »
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