Derivatives in their most basic form have been documented as far back as Antiquity. Traces of their use can be dated to 600 BC, but are most commonly assumed to have had their first commercial application during the Roman Era (27 BC – 476 AD). The Romans quickly realized (even back then!) that longer term planning was required in order to secure the food supply for Rome. Allowing food costs to rise past budgetary constraints was too much of a risk to take. It literally meant survival of the Empire.
Interesting fact: Aristotle himself is said to have written about derivatives too!
Importance of Using FX Derivatives Today
Fast forward to today, and we find that modern-day company requirements have not changed.
Increased competition, tighter profit margins and cost inflation are a reality, so it is arguably more important today for companies to execute a well-managed and comprehensive FX risk management strategy that considers all products – including FX derivatives.
The recent COVID-19 crisis has shown that many companies are mere months away from declaring bankruptcy. By not hedging they expose themselves to the all the volatility currency markets offer, which increases the risk companies are taking.
Using FX derivatives can literally mean the survival of your business.
To Hedge Or Not To Hedge
The natural counter-argument to hedging via derivatives usually involves one or more of these reasons:
- Lost opportunity cost (addressed in future blog post)
- Increased hedging costs (addressed below)
Before we go any further I want to make it clear:
Our firm’s first-hand, practical experience suggests companies who employ some level of hedging have managed the COVID-19 and other crises – on average – better than those who let their FX exposure be dictated by the wild gyrations of the currency market.
Now, it is true that wide interest rate differentials between certain currency pairs can make hedging costly (e.g. INR vs. CAD). However, if you are a company trading in USD vs. CAD the cost of hedging is one of the lowest globally! There is no reason for this to be a concern.
The Use Of Financial Derivatives By Canadian Firms
A publication released by the Bank of Canada in 2014 examined publicly listed Canadian companies that used financial derivatives (forwards, options and swaps). One key takeaway that is applicable to every company of every size is:
“Non-financial firms that use derivatives are typically larger and more profitable and have lower volatility of earnings than those that do not use derivatives.”
“Financial derivatives such as forwards, futures, options and swaps allow corporations to protect themselves from unpredictable changes in exchange rates, interest rates and commodity prices, thereby reducing the degree of financial risk to which they are exposed.”
The table below (from the BoC report which can be found here) is the best part. It contrasts several financial metrics between Corporate Hedgers and Corporate Non-Hedgers.
Source: The Use of Financial Derivatives by Canadian Firms, Bank of Canada, 2014
In brief, Corporate Hedgers experience:
- Higher Return on Assets (ROA)
- Lower Volatility ROA
This stands as a strong motivator for all companies to consider the use of derivatives in their FX strategy. If you want to grow your business and become more profitable you must manage risk!
Until next time…
Alexander Grant, FRM is Olympia Trust CGP’s Senior FX Strategist. He can be reached at firstname.lastname@example.org if you have questions.