Foreign Exchange Risk

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W HITE PAPER

Managing Foreign
Exchange Risk
The Canadian dollar has made the headlines on numerous occasions in recent years. Its value has changed significantly and rapidly many times, greatly impacting the sales and profits of Canadian companies that do business outside of Canada. When asked, in many surveys, what factors prevented them from increasing their export levels, Canadian companies identified fluctuations in exchange rates as the Number One factor. Studies have also shown that many Canadian companies, particular small and medium-sized ones, lack basic knowledge on how to manage foreign exchange risk. In response to this, EDC has prepared this document which serves as an introduction to the subject of foreign exchange risk. In it, the reader will learn, namely, why it makes sense to reduce the company’s exposure to currency risk, and find out more about the common techniques and instruments that can be used to mitigate this risk.

Table of Contents
3 Introduction to Foreign Exchange Risk
3 What is Foreign Exchange Risk?
4 Why Hedge Foreign Exchange Risk?
4 Managing Foreign Exchange Risk
6 Common Techniques and Instruments

E DC | Managing Foreign Exchange Risk

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Introduction to Foreign Exchange Risk
Figure 1: USD/CAD Exchange Rate – January 2005 to January 2010 1.10
1.05
1.00
0.95
0.90
0.85
0.80
0.75

Source: Bank of Canada and EDC Corporate Research Department

January ‘10

July ‘09

January ‘09

July ‘08

January ‘08

July ‘07

January ‘07

July ‘06

January ‘06

July ‘05

January ‘05

0.70

In recent surveys, Canadian companies active in international markets have indicated that the Number
One constraint to export growth is
volatility in the value of the Canadian
dollar (Figure 1). This is understandable given the never-ending fluctuations in exchange rates of all
freely-traded currencies. Short-term
fluctuations make it difficult for
exporters to price their products
and to forecast how many Canadian
dollars they will be paid since export
sales are frequently invoiced in the
foreign buyer’s currency.

Canadian companies that import goods and services, or have significant long-term assets and liabilities in a foreign currency, are also impacted.

What is Foreign Exchange Risk?
For Canadian companies that sell their goods and services internationally and get paid in a foreign currency, foreign exchange risk is the likelihood that a change in exchange rates will result in the company receiving a lower amount of Canadian dollars than originally anticipated. For Canadian companies that import and pay foreign suppliers in foreign currency, it is the likelihood that a change in exchange rates will mean the company has to pay more than planned. This form of foreign exchange exposure, which impacts the cash flow of the company, is commonly referred to as transaction exposure.

Other forms of exposure also exist, such as accounting exposure and economic exposure. Accounting exposure applies when assets and liabilities denominated in a foreign currency need to be converted into Canadian dollars for accounting purposes. The conversion normally results in foreign exchange gains or losses. This is of particular concern to Canadian companies that have foreign subsidiaries, but can also impact companies that export and import. Economic exposure relates to the overall impact that exchange rate fluctuations can have on a company’s value. Canadian companies that only sell domestically can also face economic exposure when, for example, the Canadian dollar strengthens and improves the competitive position of foreign producers.

For most firms, managing foreign exchange risk centres on how to mitigate transaction exposure. This paper focuses on this type of exposure.

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Why Hedge Foreign Exchange Risk?
For some companies, managing foreign exchange risk may seem too complex, costly or timeconsuming. Others may...
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