If you have a Canadian customer who’s doing business abroad, chances are they have a foreign exchange (FX) hedging strategy in place—or they’re planning to implement one in the future. But every day they operate without one, they’re putting their company’s profit margins at risk—especially in this current, highly volatile currency environment.

This article will examine various FX hedging strategies available to exporting companies. We hope you find it useful as you advise your customers on what their options are, and on how to optimize their international growth while mitigating their FX risk.

At the same time, we’ll present a solution that not only works for your customer, but also works for you: to minimize your financial institution’s (FI) risk and protect potential revenue from your exporting customers.

Getting Started

Foreign exchange is an integral part of every international business. It can be risky, so companies need to account for those risks to avoid potentially devastating losses. While fluctuations in the value of the Canadian dollar were an issue before the pandemic, managing market risk is more important now than ever. Not only are companies dealing with increased market risk, some FIs are understandably requiring more security to cover these risks, which means your customer may have to put up additional collateral on their loans. Supply chains are also being disrupted, making it difficult for businesses to know when they’ll receive the supplies they need, be able to ship their products, or more importantly, get paid.

Bottom line: companies need to look at foreign exchange risk management with the same level of dedication and detail as they do other financial risks. When they protect their costs and sales with an FX hedging strategy, they can:

  • Be confident in pricing their contracts, knowing their profit margins, and paying their suppliers without the fear of losing money;
  • Accurately budget their revenues and costs in Canadian dollars; and,
  • Ensure they have the necessary working capital available to pursue new business opportunities, both domestically and abroad.

When choosing the best approach to hedging FX risk, companies need to analyze their individual needs and capabilities. For example, some companies protect only confirmed sales while others protect forecasted ones. Factors such as risk tolerance, the impacts on earnings due to exchange rate fluctuations, and the predictability of future sales will influence their decision.

Common FX Hedging Tools

A shield with a pile of coins

Forwards

Forward contracts are the most widely used by Canadian exporters. They provide the ability to lock in a fixed FX rate—not necessarily at the current exchange rate—on a transaction for a specific date in the future. This can be a good plan if a currency’s value is expected to fluctuate significantly. Forward contracts allow businesses to forecast sales and revenues with relative certainty, which is helpful in building a competitive pricing strategy. The drawback is that, on the agreed upon date, they’ll be obligated to settle their contract or purchase the currency to which they committed, even if their customer has yet to pay.

Another type of forward contract is a window forward. With this contract, a company can buy or sell currency as many times as necessary within a certain time period (known as “windows”) to close the contract. Window forwards are more expensive than standard forward contracts, but they make it easier to make payments towards a contract based on when the exporter gets paid by their customer.

A bar graph with two arrows circling around clockwise

Options

Currency options extend the right—but not the obligation—to buy a certain amount of currency at a future date. Because these options don’t require the buying or selling of foreign currency (unlike forward contracts), they’re highly f lexible and often used by companies that bid on contracts. Currency options protect against foreign exchange risk, while still allowing companies to profit from fluctuating exchange rates. This is why some carry an upfront cost. On the downside, if the currency never shifts in the company’s favour, their cash may be tied up to secure the contract without ever having used the option. There are a variety of available options, but many are complicated. It’s important to work closely with your customer to determine the best fit for their individual risk management strategy.

A pile of coins with arrows on top and bottom going different directions

Currency Swaps

Currency swaps involve selling and buying foreign currency at the same time, helping companies align their receipts and payments. They combine aspects of a spot rate (buying or selling a foreign currency at the current market rate, for delivery within 24 to 48 hours) and a forward contract. While there are no direct costs for purchasing swaps, collateral may be required. Currency swaps can be used to advance or prolong a forward contract, or to synchronize cash flows. They are favoured by businesses facing unexpected currency inflows and outflows and can be used for cash management.

FX Hedging Tools Summary

All of these FX instruments have associated risks. To ensure your customer is adequately managing these risks, they need to take an active approach that typically involves using more than one of these tools. Without an effective hedging strategy in place, they’ll no doubt end up on the losing end of volatile currency markets, putting their profit margins at risk, if not their entire company.

One thing is certain: enabling your customer to pursue new global opportunities is in their best interests—and yours. Having to use part of their working capital to collateralize their FX contracts—through their operating line or general security agreement—can act as a deterrent in implementing an effective FX hedging strategy. In fact, many exporters point to the threat of depleting their working capital as the primary reason why they delay hedging for as long as possible, no matter when the FX risk actually appears.

But there’s a simple solution.

EDC Foreign Exchange Facility Guarantee (FXG)

Export Development Canada’s (EDC) Foreign Exchange Facility Guarantee (FXG) eliminates the need for your customer to post collateral as payment assurance against the FX contract you extend to them. At the same time, it provides your FI with a 100% guarantee on the required collateral amount. With currency rates locked in, your customer is better able to price contracts and project revenues. But most importantly, having full access to their cash flow means they can more effectively deliver on existing contracts, and pursue new opportunities.

Having mitigated their FX risks—and now in a better cash position overall—your customer is more creditworthy. They’re poised for accelerated growth and will likely rely on your FI for additional financial solutions to support this growth.

The cost of this prepaid protection is based on your customer’s risk rating, the amount of the guarantee and the maximum length of FX contracts allowed under your FX facility.
 

a group of coworkers taping into each other’s hand happily

FXG benefits to your customer

· Protects profit margins by locking in exchange rates—without tying up working capital

Without the need to post collateral to secure an FX hedge, your customer will have more available working capital, allowing them to take on more opportunities, explore expansion plans, and grow their business.

· Takes the guesswork out of FX budget forecasts

By locking in a rate in advance, your customer will be more confident when pricing their products or services, which will increase the accuracy of their cash flow forecasts.

· Increases borrowing capacity

Because your customer can secure FX contracts without posting collateral, they optimize their cash flow and increase their creditworthiness— ultimately improving their further borrowing capacity and growth.

· Improves cash flow management

Margin calls (the amount required as collateral for your customer’s FX hedge) can be unpredictable. With an FXG, your customer doesn’t need to meet those calls until the maximum liability of the guarantee is reached.

· Provides access to more sophisticated FX tools

With an FXG supporting the inherent working capital constraints accompanied by advanced hedging, your customer can book longer FX contracts—of up to three years—and diversify the types of FX instruments they use.

                   

FXG benefits to you

· Standalone business development tool

FXGs can be leveraged as a standalone, non-client facility, offering an ideal foot-in-the-door for new customer prospects.

· Provides a 100% irrevocable and unconditional guarantee on the collateral or margin requirement

EDC will issue a 100% guarantee to your FI for up to the full collateral requirement, waiving the need to freeze your customer’s credit line.

· Offers flexible timing

Leveraging the protection of an FXG can be done at any time during the life of a contract.

· Increases lending capacity and revenue streams

Similar to the customer benefit noted above, without the need to post collateral, your customer has full access to their working capital. This can translate into additional business expenditures, creating new revenue opportunities for your FI.

· Offers customized coverage

The percentage of coverage can be tailored to support only a portion, or the total FX risk, making it a flexible solution tailored to both your customer’s and your FI’s needs.

Noteworthy: An FXG also works for domestic companies that sell into exporting supply chains.  Even if your customer isn’t directly exporting their finished good or service, if they’re importing products from foreign suppliers (and therefore subject to FX risk), then selling their finished goods into an exporting supply chain, they can be covered by an FXG.

A business women is standing on the edge of building window

FINMETRIX is an independent financial risk management consultancy that specializes in currency, interest rate and commodity risks. According to company general manager, Antoine Lajoie, building an FX hedging strategy involves answering three key questions:

1. How long should your term be?

2. What ratio should you hedge?

3. Which product should you use?

“How you answer those questions really boils down to your business DNA, so the answers will vary based on your individual circumstances. It’s all about understanding the dynamic with your clients, suppliers, competition, the certainty of your contracts, and so on. If the best FX hedging decision for you comes with a collateral requirement or term limitation from your bank or broker, then EDC’s FXG is a perfect solution. By providing guarantees, EDC can help companies hedge their currency risk while avoiding restrictions on their working capital.”

Antoine Lajoie, General Manager FINMETRIX Inc.

For more information

Contact your EDC account manager or our customer care team at 1-800-229-0575 with any questions about the Foreign Exchange Facility Guarantee or to get a quote for an FXG covering your client’s FX hedging limit.

                   

Date modified: 2024-07-10