The new era of FX management
Why currency markets are now top-of-mind for many small- and medium-sized manufacturers.
By Will Stanley.
Two decades ago, the practice of foreign exchange (FX) management was reserved primarily for multinational corporations and commodity traders. Today, with Prairie merchandise exports at an all-time high, it is an in-demand skill set that has become mission critical for even the smallest manufacturer.
Few executives know this better than Casey Davis.
Davis is the CEO of Morris Industries, an agricultural implement manufacturer with operations in Saskatchewan and Manitoba, and sales in more than a dozen markets around the globe. Although exports currently account for half of the company’s annual revenue, international sales have spiked as high as 80 per cent in recent years. At any given time, Davis estimates Morris Industries is dealing in at least a handful of different currencies.
“There was a time when we would be measuring foreign purchases against sales quarterly at best,” he recalls. “We’ve accelerated that quite a bit, especially leading up to our fiscal budget cycle. Now, we’re often looking at what currencies are doing twice a day.”
For Davis, it’s a matter of competitiveness. Educated as an accountant and lawyer, he views FX management as an intrinsic part of the profitability equation — one that rewards proactivity and penalizes imprudence.
This has become acutely true since the recession. Growing market volatility, coupled with political instability across many major Canadian export markets, has translated into historic currency swings. The Russian ruble, for instance, has fluctuated more than 250 per cent in the last eight years, and — at its lowest point — shed nearly a quarter of its value in 2016 alone.
“Currency is all about global competition,” says Davis. “That’s why we need to be keenly aware of what it’s doing. Decisions we make on how to manage currency have a direct correlation to changes in demand.”
Andrew McGuire couldn’t agree more. The CEO of AgilityForex, a prominent Western Canadian currency broker, is seeing many more small- and medium-sized manufacturers seizing control of their FX risk.
“Companies need to take the bull by the horns,” says McGuire. “Having some lazy positions in currencies can completely wipe out profit margins. Look no further than what’s going on in Britain. The sterling has moved 10 per cent in only the last couple months.”
The key, he adds, is knowing what tools are available.
“The most obvious mechanism is for a company to perform a transaction for a future forward date. So, if you know you’ll be receiving foreign funds in three months, or if you’ll be taking possession of supply, you can lock in the rate you’ll be paying today so you can better plan your cash flow.”
Other tools regularly used by companies include options, swaps, factoring, and natural hedges (see sidebar).
The latter has been particularly effective for Morris Industries. As a large product manufacturer with a heavily integrated global supply chain, the company has been able to hedge much of its risk exposure by adjusting where it sources inputs and materials relative to foreign sales levels.
For Prairie manufacturers, natural hedging is most prevalent with the U.S. market and USDs. Morris Industries is no different.
“We do buy a lot in foreign currency,” explains Davis. “This goes back to when the dollar started strengthening again. Before we got to $1.05 or $1.08 (CAD versus the USD), we had already converted much of our large items — tires and steel — to U.S.-based purchases.”
Deciding which currencies to sell in — and hedge against — is the first question exporters must answer. And there are many considerations to take into account: What makes it easiest for your customer to do business with you? How important to you is transaction speed? How sophisticated is the banking system in your sale market?
Another important decision is determining what insurance products to purchase. Accounts receivables insurance and bank factoring insurance are both policy types that can help mitigate the risk of getting paid while managing currency movement.
It all comes back to having a plan — a plan, notes McGuire, that is as easy as one, two, three.
“The first thing manufacturers must do is calibrate their exposure to risk,” he says. “For most companies, the focus is on transactional risk.”
One way to calculate transactional risk is to subtract expected foreign currency receivables from expected payables over a set timeframe. The net difference is the exposure to be hedged.
“The second step is to review all the financial and natural hedging tools at your disposal, and develop policies detailing when and how to use each of them.
“And the third step is to measure and review your activity on a continual basis. Currency markets can change rapidly; so, although one tool may be right for you one day, it may not fit your risk profile the next. As with any part of your business, the trick is to be informed, patient, and deliberate.”
Hedging instruments
Forwards – Forward contracts, or forwards, are available from most banks and brokerage firms, and allow a company to lock in a price that it will either sell or purchase a foreign currency at in the future. This tool generally has no up-front purchase price, but requires collateral against the amount hedged in most situations.
Options – Currency options are similar to forwards, but give companies the right — not obligation — to buy a foreign currency in the future at a pre-determined price. This flexibility makes it a useful tool to manage downside risk, particularly for companies bidding on contracts, but are subject to an up-front cost.
Swaps – Swaps are simultaneous transactions in which a company both buys and sells a foreign currency at a pre-set rate. This is most commonly used to balance receipts and payments that are separated by a determined period of time. Simply put, it is a combination of a spot transaction and a forward, with no up-front cost.
Factoring – Financial institutions specializing in factoring may purchase from you foreign trade receivables, providing you cash flow and working capital, and relieving you of time-consuming credit and debt collection activities.
Natural hedge – A natural hedge is a strategic approach to mitigating risk by increasing or decreasing inputs paid for in a foreign currency relative to the value of foreign sales in that same currency.