Currency exchange is one of the biggest risks Canadian companies face when selling internationally, but ironically, it’s a risk many businesses ignore.
This head-in-the-sand practice baffled me for a bit, but as I talked to more and more exporters, I understood it was simply a matter of hopeful human nature. They knew a fluctuation in the exchange rate could cost them, but they secretly hoped any fluctuation would be in their favour – and they’d hate to lose that extra money by locking themselves into an exchange rate at the time of the sale.
The problem, as I explain below, is that there’s a hidden cost to your business when you don’t manage your currency exchange risk – even when the gamble pays off and your business comes out ahead financially.
Why are exchange rates so important to companies that sell internationally?
An exchange rate is the value of one country's currency in relation to another’s. For example, at the time of writing this blog, it cost $1.30 in Canadian funds to buy one U.S. dollar, or $1.50 to buy one Euro. The challenge for those who sell internationally is that currency values between countries are in a constant state of flux.
Say you sell some equipment for 100,000€ to your customer in France, and give them 90-day terms. Your expectation is that at the current exchange rate ($1.50 Canadian for one Euro), you’ll receive the equivalent of $150,000 in Canadian funds when the bill is paid.
But what if the value of the Euro drops during that time from $1.50 to $1.40 Canadian? Now you’ll only receive $140,000. It’s easy to see how the risk of fluctuating currency exchange rates can diminish or even decimate your profits on a sale.
But wait a minute, you may be thinking, what if the Euro’s value goes up to $1.60? Then you’ll gain an extra $10,000! That makes it tempting to do nothing about the risk, or assume that sometimes you’ll win, sometimes you’ll lose, and it will all even out in the wash.
The hidden cost of ignoring currency exchange risk
There are many things that can influence the value of a nation’s currency, including inflation, interest rates, its economy, the balance of trade between countries, and political instability, to name a few. But the reality is that you have no control over any of these things – an exchange rate can fluctuate at any time, sometimes drastically so.
Failing to manage that risk can hurt your business, even if you sometimes come out the winner in the exchange-rate gamble. Never knowing what loss or gain you’ll take from fluctuating exchange rates means your company is constantly operating in a sea of uncertainty. For smaller companies, especially, you can’t be sure what your profit will be for each transaction or how much cash flow you’ll have to fulfill the next contract. The cost of that uncertainty is huge. It means your company will be less competitive and may grow at a slower pace due to inadequate cash flow to fulfill contracts and pursue new opportunities – not to mention the personal stress that taking such a risk can bring.
How to manage currency exchange risk foreign exchange guarantees
Foreign exchange guarantees (FXGs) are the simplest and most cost-effective way to manage your currency exchange risk. There are three main types that Canadian banks offer. Options, or derivatives, is a more complex method not typically used by small to medium-sized businesses, so I’ll focus on spot rates and forward contracts.
Spot rate: The spot rate locks in the value of a currency “at this moment in time.” Therefore, whether the exchange rate fluctuates up or down during the period of time before you get paid, you’ll know exactly how much money you’ll be getting from a sale, and can better plan accordingly. Don’t be afraid to negotiate the posted rate your bank charges, as rates are currently coming down for this service.
Forward contract: A forward contract locks in an agreed-upon exchange rate for a transaction on a specific date in the future, which is not necessarily what the exchange rate is right now. This can be a good plan if a currency’s value is expected to fluctuate considerably. However, it’s important to note that upon the agreed date, the bank is obligated to purchase the foreign currency from you, and you are obligated to provide it. The added risk here is that if your customer is late with your payment (or doesn’t pay), you’re still obligated to the bank and will typically have to pay a penalty if you can’t provide the currency on time.
Call EDC to get around the requirement for collateral
To provide exchange rate guarantees, banks also require collateral. For the world’s major currencies, the rule of thumb is 10 percent of the volume of your contracts. So if you have $50 million in forward contracts, you’ll typically be required to put $5 million in an account with your bank as collateral. That means the money will be tied up when you could be using it to complete contracts or grow your business.
To get around this, call Export Development Canada first. We’ll explain how EDC can provide a Foreign Exchange Facility Guarantee to your bank that replaces their need for collateral, so you have currency rate protection you need without tying up your cash.
Building a foreign exchange policy
Understanding FXGs is a great first step to managing your currency exchange risk, and developing a foreign exchange policy will benefit your company even more. To get started, download Building a Foreign Exchange Policy to create a program tailored to your company’s needs.