Exporters are no strangers to risk and routinely deal with everything from late payments to shipping delays. Many exporting companies, though, don’t really pay enough attention to one particular hazard: foreign exchange (FX) risk.
FX risk is the danger that fluctuations in our dollar’s value, relative to other currencies, will affect the profitability of the company. The issue isn’t that this risk is poorly known—most exporters agree that unfavourable FX fluctuations can undermine their profits and cash flow. Even so, many of them don’t manage their FX risk in a way that helps them maintain their margins and their overseas growth.
Hedging and when to use it
The basic tool for managing FX risk is called hedging. There are numerous ways to hedge, but exporters normally use an “FX facility,” which they purchase from their bank. An FX facility resembles an operating line and can support various types of financial instruments, or hedges. These are all designed to lock in the FX rate for an export sale, reducing a company’s vulnerability to adverse rate changes. But getting the most out of hedging relies on knowing exactly when to buy an FX facility and start hedging, and this is where exporters can get it wrong.
“Many companies don’t clearly realize when their FX risk becomes a reality,” says Normand Faubert, President of Optionsdevises, a consultancy that helps exporters learn to manage FX volatility. “They often wait to hedge their FX exposure until they issue the invoice, even if they finalized both the contract and the sale price months earlier. But what they don’t realize is that their FX risk actually arose when they established the sale price, not later, when they submitted the invoice. So between those two times, maybe for months, they were fully exposed to unfavourable rate changes because they had no hedge in place. They didn’t consider their FX risk soon enough, and that is a common mistake.”
When is it too late?
In Faubert’s view, even hedging at the time of the sale may not be ideal. “Your FX risk actually appears as soon as you set your prices, even when you haven’t made any sales yet. For example, suppose you publish an annual price list in January. You’ve now committed yourself to selling at those prices for a year, regardless of what the FX rate does. If it changes adversely, your margin will shrink. So just by publishing your prices, you’ve caused an FX risk to appear, and you’d be wise to start hedging right then. To do this, you’d set up a hedge based on your sales forecast for the year, even if you don’t have any sales so far.”
This approach, Faubert acknowledges, goes against the grain for many company managers. When they haven’t yet booked many sales, they’re understandably reluctant to make an early, firm commitment to their bank by purchasing an FX facility to cover future foreign-currency transactions. But while they wait, their prices are at the mercy of the FX rate. If the dollar rises, a sale that was worth CAD 250,000 in January may bring in only CAD 230,000 in June. If they had hedged in January, though, they’d still receive the larger amount, regardless of the dollar’s gyrations.
Even so, should companies really hedge on the basis of their annual sales forecasts? Faubert thinks they ought to. “For example, suppose your market experience tells you that you’ll have U.S. sales of between $10 million and $13 million this year. This can be a reasonable basis for hedging, because even if things go badly, you’ll have sales of at least $10 million. So it would be advisable to obtain an FX facility for that $10 million as soon as you set your prices. And if you sell more than that, you can hedge the higher amount as soon as your updated sales forecast justifies it.”
The casino approach
But what about the case where the FX rate could move in a favourable direction, and a $250,000 sale in January might be worth $275,000 in June? By not hedging, the company could increase its possible profit margin—a potential benefit it would forego if it used a hedge to lock in the January FX rate. It’s a bet, true, but could it be a good one?
Faubert’s answer to this is simple: “If relying on favourable FX shifts becomes part of your export strategy, you’re becoming a currency speculator, not a business operation. Basically, you’re trying to make money in a market that’s completely unpredictable. It’s far better to disregard this casino approach and stay focused on your customers, your products and growing your company. Basing your export strategy on FX movements is very unwise—developing your business in a foreign country is a long-term decision, and you can’t possibly flip it around as fast as FX rates can change. So your decision to export should never be based on the possibility of a weakening dollar. It should come from the market opportunity itself.”
The working capital conundrum
For Faubert, the proper handling of FX risk comes down to putting effective strategies in place and then executing them, regardless of what FX rates may be doing. That said, there can be one very concrete objection to the hedging strategies he describes: their impact on the business’s working capital.
This comes back to the cost of buying an FX facility. To cover its own risks in the transaction, the exporter’s bank will require collateral from the company. This collateral can be up to 15 per cent of the facility’s value, and the bank normally takes this amount out of the company’s operating line. For many exporters, this erosion of their working capital may be a good reason to delay hedging for as long as possible, no matter when the FX risk actually appears.
There’s a solution, however, in the form of EDC’s Foreign Exchange Facility Guarantee (FXG), which provides a 100 per cent guarantee of the collateral that the bank requires for the facility. Once the guarantee is in place, the bank won’t need to cut into the company’s operating line, and the firm will retain full access to all its working capital. “The FXG,” says Faubert, “is a formidable advantage for companies that don’t want to use their operating lines as collateral for FX facilities. With an FXG in place, they can maximize their working capital and still be able to hedge their FX risk.”
In Faubert’s view, there’s a straightforward prescription for companies that want to grow their overseas business and remain profitable even in an era of FX volatility. “First, make sure you understand the nature of your exposure to FX risk. Second, be clearly aware of when your FX risk actually arises, and design a strategy to manage it. And third, hedge each risk as soon as it becomes a reality.”