Hedging Strategies For Protecting Profits In Canadian Forex Trading – Currency markets are becoming more volatile than they have been in years. The US dollar has reached a 20-year high, and there is a huge amount of geopolitical and economic uncertainty. In response, US companies of all sizes need to reassess their foreign exchange (forex) risk and hedging policies. Such hedging policies should suit business objectives by keeping currency fluctuations within a predictable and acceptable range so that companies can run their business with more operational certainty.
Despite the urgency of action, this review must be carried out systematically. Before you design a hedging strategy, some important homework and self-reflection should be done regarding the company’s objectives and risk tolerance. Otherwise, the hedging program will not work effectively. To manage this review process, consider using a four-part framework: articulating company goals and objectives, defining and analyzing foreign currency exposures, designing and implementing a hedging strategy, and reviewing and monitoring the hedging program (see Figure 1). Once established, this framework should guide an iterative and continuous process of continually improving the hedging program.
Hedging Strategies For Protecting Profits In Canadian Forex Trading
Firms’ primary objectives when hedging forecast transactions can be broadly similar, such as facilitating the effect of foreign exchange rates over time on financial performance, assisting senior management’s ability to predict financial performance, protecting budgeted results, and improving pricing of goods/services, and managing foreign exchange risks related to capital projects.
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But when setting more specific goals for a company, you first need to determine the company’s priorities and consider the different trade-offs between those priorities. The priorities and trade-offs may depend on how and where the company conducts its business. If most of a company’s sales occur abroad, a higher dollar will negatively affect its financial statements since bringing that revenue inward will result in lower dollars. On the other hand, companies that sell in the US but buy raw materials abroad benefit from a strong dollar because those raw materials are cheaper to buy in dollars. In either case, forex risk exposes companies to ongoing operational uncertainty, but their different business implications and exposures may lead to different risk management objectives.
You should also decide what financial performance metrics you want to focus on. For example, some companies focus on how forex risk affects the balance sheet. Currency fluctuations have a direct impact on recorded assets and liabilities, creditors and receivables, cash, etc. These are visible elements that must be explained to stakeholders. Thus, hedging to reduce volatility in the balance sheet is often an objective. Another reason for hedging is to reduce risks related to expected revenue and forecasts. In this situation, management wants to protect the viability of its business plan and minimize volatility on a quarterly and year-over-year basis. Various hedging programs can be used to address balance sheet risk and foreign exchange risk related to forecasted revenues and expenses.
To achieve their goals, companies should take a risk-based approach to hedging rather than a market-based approach. The objective of the risk-based approach is to reduce operational risk by keeping currency fluctuations within certain tolerable limits. This approach requires a comprehensive view of all the different types of risks a company faces and an understanding of how they fit together (i.e. how they might amplify or offset each other).
By comparison, the market-based approach is about trying to time the currency markets. The problem with this approach is that if a company is only hedging when it predicts a negative move in the foreign exchange market, it is exposed to significant risk in the foreign exchange market at other times. For example, a large US company with large overseas sales hedged each fall using a market-based approach. In 2021, it decided not to hedge against foreign revenue, arguing that the dollar was overvalued. But the dollar continued to appreciate, causing the company great avoidable financial hardship. By taking this market-based approach, the company has not properly considered other risks within the organization or considered how much forex risk is acceptable.
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A company with limited international operations may have a good intuition about its currency exposure. But once a company begins to expand its operations abroad – to build up its supply chain, for example – the complexities build up rapidly, making it more difficult to understand and mitigate the scope of risks. Thus, it is crucial to regularly perform data-driven analysis to understand how movements of a particular currency over the next 6, 12, or even 24 months will affect a company’s balance sheet exposure, projected cash flows, or a particular event such as a planned event. acquisition. The key question for executives is what level of negative consequences can the company sustain?
As mentioned earlier, a risk-based approach requires an overall view of how all of a company’s risks fit together. For example, a company’s risk exposures may partly interact and can partly offset each other, creating “natural” hedges. Consider the following hypothetical example of a US-based company with large global sales (see Figure 2). If you add up the single currency risk exposure (Australian dollar, -12.6m, Canadian dollar, -14.9m, Euro, -6.4m, and Mexican peso, -34.9mm), along with natural gas (-88.4m) and interest. Exposure to interest rate risk (-0.8 million), the amount indicates that total net income could be about $160 million less than expected (with 95 percent confidence). But these different risks do not move in sync, so simply adding them up does not give you a real understanding of the company’s exposure and hedging requirements. Based on the historical correlations in this example, the diversification benefit reduces risk by about $60 million, so the company’s exposure on a portfolio basis is estimated to be $96 million.
After you have done the homework to understand your objectives and analyze your currency exposures, it is time to design a hedging strategy. Therefore, in Figure 2, a well-designed forex hedging strategy may not involve 100% hedging on each of the four currencies, because that would negate some of the natural hedging between currency and natural gas risks. Better to build a hedging strategy that takes advantage of any free diversification benefit; In the example above, perhaps only portions of individual currency transactions should be covered. The art and science of designing a hedging strategy is to determine the minimum amount of hedging necessary to achieve the target level of risk, while keeping costs down and reducing operational complexity, and to understand the trade-off between the level of target risk and the cost and complexity of the hedge. . Determining which strategies are efficient in terms of risk and cost/complexity, or what is known as the “limit of effective hedging”, is often not obvious without a deep analysis.
All of this hard work in clarifying objectives, assessing currency exposure and designing a hedging strategy will not work if the company does not systematically implement the forex hedging program over the long term. This means writing down the hedging policy, outlining how the company will implement it in the future, including carrying out new hedges every month and every quarter.
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The Company should not endorse or oppose the forex hedges it places. It is not appropriate to say, “We ran out of money on that hedge, so we shouldn’t have done that.” Instead, the company must judge the hedging strategy on whether it keeps currency fluctuations within an expected and acceptable range for running the business over a six-, 12- or 24-month period.
Firms should regularly evaluate their foreign exchange exposures and the effects of their hedging programmes, incorporating new data whenever possible and in a prompt manner.
With currency markets more volatile than they have been in years, it is important for companies to re-evaluate their foreign exchange hedging programs in the current environment. It’s a complex task, but the four-part framework can help companies systematically address challenges and ensure that the program remains effective for years to come.
Eric Merlis, Managing Director and Co-Head of the Global Markets team, is responsible for interest rate derivatives, forex, commodity sales and trading groups. He holds an MBA in Finance from Southern Illinois University at Carbondale and a BA in Philosophy from Siena College.
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Securities products and services are offered by Citizens JMP Securities, LLC, Member FINRA, and SIPC. Citizens Capital Markets, DH Capital, Trinity Capital and JMP Securities are brand names of Citizens Financial Group, Inc. Note: Any testimonials provided apply to the individuals depicted and may not represent the experience of others. No testimonials are paid and do not indicate future performance or success. Foreign exchange risk management and hedging solutions help your business manage and mitigate fluctuations in the foreign exchange market. We understand that participation in the global market on any scale can bring great opportunities, while offering unique foreign exchange exposure. Whether you’re buying machinery from vendors, selling parts to customers, or paying rent across borders, currency exchange rates can create uncertainty about your bottom line.
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