What’s currency risk?
Selling or buying internationally means making transactions in foreign currencies. However, currency rates change rapidly. Depending on how much a rate rises or falls, your invoice may be higher or lower. For example, when the exchange rate rises, you’ll have to pay more to your suppliers. When it drops, your sales will bring in less than expected. This is called currency risk.
A business is vulnerable to z when the value of its transactions and investments, not to mention its viability, are affected by currency rate fluctuations.
If this is the case for your business, it may be difficult to manage its profitability. But it’s a reality that all entrepreneurs have to plan for.
Why do currencies fluctuate?
The foreign exchange market moves in step with the decisions of international investors who favour one currency over another. Currency rates are therefore essentially driven by the law of supply and demand. This is based on various factors, the main ones being:
The stability and economy of different regions
If region A is stable and growing while the economic and political future of region B is uncertain, investing companies will favour the currency of region A.
Furthermore, if international geopolitical tensions or fears of a global economic crisis occur, the value of currencies considered to be safe havens, mainly the U.S. dollar, may rise.
Product demand
If products from region A are in high demand, buyers will want more of A’s currency in order to purchase these products.
For example, the strength of the Canadian dollar is often linked to the global demand for natural resources. As our country has a large supply of them, the value of our dollar rises when demand for these resources is high.
Interest rates
If interest rates in region A are higher than those in region B, international investment firms will choose to invest in A’s currency. This is why the Canadian dollar appreciates when domestic interest rates rise.
Inflation rates
If the inflation rate is higher in region A than in region B, A’s currency will lose value faster and investment groups will favour B’s currency. This is why when inflation increases in a country, the value of its currency usually decreases as well.
To summarize, all of these factors could cause the currency rate of one of your transactions to fluctuate up or down between the time of a sale or purchase and the time of payment.
How do currencies affect the value of your business?
Currency rate fluctuations can also have an impact on the future value of your business, its competitiveness in the medium or long term and your investments.
- With currency transaction risk, failure to protect your future transactions could expose your business to significant losses. For example, if the exchange rate changes unfavourably between the time you make a sale or accept a quote and the time you receive payment or pay your supplier, you’ll suffer what’s called a dead loss.
- With economic risk, your foreign assets, investments or financing could depreciate and reduce the value of your business. For example, a Canadian company with assets in the United States is at risk if the U.S. dollar depreciates. Conversely, a Canadian company with bank financing in the United States is at risk if the U.S. dollar appreciates, because the amount to be repaid is then higher in Canadian dollars.
- With currency conversion risk or accounting exchange risk, changes in currency rates could adversely affect the financial statements of an international business when consolidating the results of foreign subsidiaries.
How can you protect your business from currency risk?
Do you trade internationally? You can use several tools to protect yourself against market movements. The best option is often a combination of several solutions. Specialists can help you determine which tools are the most advantageous for your situation.
Here are some of the solutions available to businesses:
Forward contract
This is the simplest and most frequently used tool. It allows you to manage currency risk by fixing your currency rate in advance. This eliminates 100% of the risks associated with market fluctuations.
For example, an exporting company expects to receive US$500,000 in three months. Since its project costs have been established in Canadian dollars, if the U.S. dollar were to lose value against the Canadian dollar during those three months, its profit would decrease. By using a forward contract, the company can fix the rate that will apply at the time of conversion.
Range forward
A range forward protects against adverse market fluctuations while providing more flexibility. Rather than a fixed exchange rate, this strategy involves negotiating a range in which the exchange rate will be allowed to fluctuate in advance.
The company in our previous example could obtain protection that would guarantee a conversion rate between 1.2500 and 1.3200 for X amount on a specific date. If the markets are favourable, the company will benefit up to a certain point but remain protected in case of unfavourable movements.
Currency option
This tool offers valuable protection without limiting the possibility of profiting from a favourable market. The currency option is flexible and offers several possible combinations. To use it, a business must pay a premium, but this option still remains very advantageous.
For example, it’s ideal for a company bidding on a construction contract in the United States. With the currency option, the company is protected if it obtains the desired contract. Conversely, if it doesn’t obtain the contract or if the market is favourable at the time of the transaction, it will have no obligations to respect. In either case, the company will only have to pay the value of the premium.
Currency swap (reciprocal credit agreement)
A currency swap, or reciprocal credit agreement, simultaneously combines two foreign exchange transactions in opposite directions on different transaction dates.
In the vast majority of cases, the swap consists of a spot transaction and a forward transaction in the opposite direction. The main advantage is that the rates of the two opposite transactions are fixed at the same time, which eliminates currency risk.
This is a good option for businesses with accounts payable and receivable in the same currency but with cash receipts and payments on different dates.
Good to know: Most of these risk management solutions are based directly or indirectly on the forward exchange rate. This is the exchange rate provided the day of by a financial institution for a transaction to buy or sell a certain amount of foreign currency on a predetermined future date.
Policy for managing currency risk
If you regularly trade in foreign currencies or are considering doing so, it’s best to establish guidelines for managing currency risk within your business. By drafting a currency risk management policy, you’ll be able to conduct an in-depth analysis and better plan your future transactions. This will encourage you to ask the right questions and choose the most appropriate solutions in advance. It’s a good idea to review your policy regularly.
Not managing currency risk is like speculating on the future of your business while betting that the markets will always move in your favour. Being well protected against currency risk will strategically reduce your exposure to market risks and may even become a competitive advantage.
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