Risk of Ruin: The Continued Case for FX Hedging

Posted by Alexander Grant on 2/15/22 10:21 AM

Hedging FX Risk can Protect Your Company’s Expected Profits and Ability to Access Funding

business-cover

The purpose of this article is to give readers a better understanding of the foreign exchange risk involved with foreign currency exchange market exposure.  

To this end, a while ago I wrote an article entitled Why Every Business Should Use FX Derivatives.  The motivation behind it was a publication released by the Bank of Canada in 2014 studying the effects of using (and not using) forex market derivatives on the publicly traded Canadian corporate marketplace.  Below are the findings of the study:

The Use of Financial Derivatives by Canadian Firms

Source:  The Use of Financial Derivatives by Canadian Firms

The first page of the publication reads:

“This topic is currently important because during the 2009–13 period, commodity prices and the Canadian dollar fluctuated significantly compared with earlier periods. Such fluctuations can result in unpredictable profit margins and losses for corporations. In turn, holding all else equal, profit volatility can increase firms’ probability of distress and impair their ability to access external funding. To the extent that the Canadian economy relies on export revenues, hedging through the use of financial derivatives can smooth income from exports and ultimately enhance domestic welfare.”

Three Key Takeaways About Foreign Currency Risk

  1. Adverse FX market fluctuations can result in company losses

  2. Profit volatility can hinder the ability to access funding (when it’s needed most)

  3. Profit volatility can increase a company’s probability of distress 

If you are in the business of managing currency risk this paragraph is worth reading again and again.   It’s the large, unforeseen foreign currency market moves that should be the focus of your company’s hedging strategy.

Average Thinking About Foreign Exchange Risk

When we think about risk it’s normal to want to think of the impact of adverse market moves as a single risk factor, or even worse reducing it to a single number.   

For example, we might think there is a 30% chance of continued supply chain shocks (it’s 2022) which would result in a loss of $500,000. Simple statistics would state your expected loss is $150,000 (30% x $500,000).  So, the two outcomes are $500,000 with 30% probability and $0 with 70% probability.  

Visually, you have:

Risk of Ruin

The issue, of course is if the $500,000 loss occurs it can have a material effect on the company. Or worse yet, multiple $500,000 losses in a short period of time!   

Risk of Ruin 

To expand on this last point, we can look at the concept of Risk of Ruin (or Probability of Ruin).  For the mathematically inclined, it’s defined as:

formula for risk

Where A = win % - loss %; U = maximum # of consecutive losses before ruin

Now, don’t worry about the rationale behind the formula.  The point is that the more foreign currency risk you are exposed to, the more likely it is you will experience an adverse FX market event that has a significant impact on your company.   

This is why hedging your FX exposure is so important to offset currency risk. 

Graph od risk

Foreign Currency Hedging Strategies

The foreign exchange market is a dynamic and ever-changing beast. For market participants, it’s important not only to keep up with trends but also take proactive steps that mitigate volatility risk by stabilizing cash flows and protecting the exchange rates budgeted for foreign currencies.

In order to hedge currency risk, you need to enact strategies that will serve as an insurance policy, should the price of an exchange currency suddenly change. This process begins with pinpointing your exposure to exchange rate risk in order to develop a cohesive strategy about what to do (and when to act) under changing FX market conditions.    

Forex hedging strategies can employ a wide variety of techniques and financial instruments, however, forward contracts and currency options are among the most popular for both large and small businesses when it comes to hedging their currency exposure, so let’s take a closer look:

FX Forward Contracts

With an FX forward contract, you can protect yourself from the fluctuations of foreign exchange rates by locking in your exchange rate (for a purchase or sale) at a predetermined date.

Say, for example, your company has a payable or receivable with a 90-day term. This kind of time frame can be a long time in the markets, with lots of potential for price changes in both directions. Depending on the movements of the market, you could wind up being saddled with higher costs or see the value of your receivable diminish. Through the use of a forward contract, you can lock up an exchange rate, which offers your company predictability and protects your margins from currency fluctuations. 

Features of Forward Contracts

  • Forwards protect businesses and investors from uncertainty by setting an exchange rate well in advance of a future date. 
  • Flexible terms make it easy to adjust forwards to your particular business needs and credit arrangements, as they can be left open for a certain period of time or settled at a predetermined date. 
  • Exchange rates are determined based on current forward rates and the spot rate at the time of the contract. 

Foreign Currency Options

Options are derivative products, through which you gain the right to buy or sell a currency pair at a particular price. Options, as their name indicates, give you the opportunity – not the obligation – to buy or sell, and they come with an expiration date. 

Say, for example, you make a call option, buying some amount of CAD/USD, but some new information suggests that there could be a decline in price. If you were to then make a put option for an equal amount of currency, you can effectively protect yourself from losses, as the profit from the put hedges against the decline on the call. 

Features of Currency Options

  • When used properly, currency options protect you from unfavourable exchange changes, and they can allow you to benefit when the rates move in your favour. 
  • Taking out options involves paying a premium, based on a number of factors. 

Options and forwards can be the cornerstone of an effective hedging strategy, but there are many more ways to protect your company from currency risk and protect your profits. 

If you want expert input to help you develop an effective hedging strategy, contact Olympia Trust Currency & Global Payments for currency exchange and global payment solutions tailored to your needs. 

Until next time…

Alex

Alexander Grant, FRM is Olympia Trust CGP’s Head of FX Options Trading. He can be reached at granta@olympiatrust.com. Information provided is for informational purposes only.  It is not investment or trading advice, or solicitation for the purchase or sale of any financial instrument. 

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