Currency exchange rates are volatile and can add extra risks in doing business with foreign companies.
When exchange rates are not fixed when the business deal is finalized, one of the transacting parties usually loses regarding costs, profits, or cash flow. It all depends on whose currency is taking the drubbing.Disregarding the possibility of currency exposure is, in sum, a bad business practice.
An illustrative example
In the 12-month period ending April 2018, the exchange rate between the Canadian and U.S. dollar dropped from a high of $1.36 in May 2017, to $1.29 at market closing on April 1, 2018.
Say that on May 1, 2017, a Canadian firm contracted to deliver $300,000 worth of goods to an American customer with the final delivery and payment due May 1, 2018. Between the contract and delivery dates, the exchange rate dropped 5 cents in favour of the U.S. customer.
The result of that 5-cent currency fluctuation would be a significant loss of $15,000 in profits for the Canadian firm. That loss is substantial. Not hedging would be the difference between a profitable deal and a non-lucrative deal. In fact, about half of all small businesses that go under during their first five years in business fail because of unmanaged costs and cash flow concerns.
"Volatility is the problem; hedging is the solution."
To guard against currency exchange volatility, many Canadian and U.S. firms are resorting to hedging. Hedging involves very simple and traditional tools to protect your business from the impacts of currency exchange rate fluctuations.
Currency hedging involves the following:
A forward contract allows you to purchase a certain amount of foreign currency at a predetermined exchange rate. A forward contract locks in the exchange rate valid at the moment, guaranteeing the cost of payable or receivables irrespective of market volatility.
Forward contracts do not involve any upfront payment and can be tailored both to a particular amount as well as a product delivery date range.
The hypothetical Canadian company that took the additional $15,000 currency exchange cost would have avoided the loss by locking in a fixed exchange rate for up one year. Also, the company would not have had to commit any cash flow in advance of the contract.
Placing a market order
A market order allows the client to request a foreign exchange conversion for a specific amount at a given exchange rate. Similar to a stock market transaction, the order is placed, and the buyer is not required to monitor the market. When the exchange rate reaches the amount specified in the market order, the buyer is notified, and the order is filled.
There are two types of market orders:
1) limit orders, which target exchange rates better than the current market rate
2) stop-loss orders, which protect against market volatility by setting a worse-case exchange rate.
Limit orders allow the client to target an exchange rate that is better than the current market rate. On the other hand, stop-loss orders protect against market volatility and set the lowest exchange rate that the client will tolerate.
Currency exchange rate volatility can affect the real cost of overseas transactions. If that cost is higher than expected, budgets can be skewed, and growth stunted. Attempting to convert foreign currency transactions on a Spot basis adds an unwise element of unpredictability and uncertainty to cost and income projections.