Small businesses that do any sort of transactions across international borders face potential foreign exchange risks. International clients may have to convert their home currency into Canadian dollars before paying you, or you may need to buy raw materials from another country for use in your manufacturing process. In either case, an unfavorable exchange rate can hurt your bottom line. Hedging can help reduce this risk.
What is Hedging?
Hedging is a way to reduce certain financial risks by buying or selling certain types of financial assets or contracts. Doing this helps protect individuals and businesses from losing too much value if something catastrophic happens. Many people engage in hedging in some way without even realizing it. If you own any sort of insurance policy, you’re hedging against a larger loss. For example, many people own home insurance policies for financial help in the case of natural disasters, and most purchase policies on their automobiles to cover replacements, expenses, and liabilities if accidents occur.
You can also hedge against a currency exchange rate. This can help reduce business losses if the exchange rate between the Canadian dollar and the currency you use for international transactions swings too far. Without hedging, you risk losing either lots of value from your international revenue or paying too much money for goods or services coming from other countries.
How Can You Hedge Currency Swings?
Since currency exchange rates are financial in nature, you need to buy or sell financial product to hedge against a large exchange rate movement. These products typically include exchange-traded funds (ETFs), currency futures, and currency options. ETFs are similar in nature to mutual funds, while future and options are more complicated derivatives products that require a bit more financial expertise to use effectively.
When hedging current risk, if you think the exchange rate between the Canadian dollar and the other currency is going to get stronger, meaning the Canadian dollar gains more value, you want to buy the product you hedge with, which is known as “going long.” If you think the rate has the potential to weaken, meaning the Canadian dollar loses value, you should “go short” or sell it. Both going long or short remain useful options, depending on the specific transaction you wish to hedge.
A Simple Example of Currency Hedging
Let’s assume a current Canadian dollar to U.S. dollar exchange rate of $0.75, meaning that one Canadian dollar equals $0.75 U.S. dollars. Now assume you know that in six months, you must pay a United States company $10,000 in U.S. dollars for raw materials. Currently, that would cost your business about $13,333 Canadian dollars ($10,000 / $0.75). Assume the $13,333 comprises your total budget, and you can’t afford any more than that.
To prevent an unfortunate outcome, you can buy a financial contract that locks in the rate to eliminate the risk of your costs changing. Let’s say your buy that contract and six months down the road the Canadian dollar to U.S. dollar exchange rate moves to $0.65. In this scenario, the Canadian dollar weakened, and those raw materials now cost about $15,385 Canadian dollars ($10,000 / $0.65). By hedging the currency risk and locking in your rate, you saved your business $2,052 Canadian dollars, which might make the difference between closing your doors and staying in business.
Hedging for currency swings is a great way to protect against wild shifts in the exchange rate. Your revenues may be stronger and your expenses lower if you manage your international transactions with proper hedging. You should also remain aware that hedging currencies can be complicated at times, making seeking out a qualified financial consultant to help you with the process a good idea.