Foreign Currency Risk

Every time you hold foreign currency or claims to foreign currency (receivables and payables) you incur foreign currency risk. Quite simply, it's the risk that exchange rates will change, which they invariably do.

If you are a Canadian company and a significant portion of your revenues comes from the us, but all your payables are paid to Canadian companies, you will win when the us dollar exchange rate goes up but will lose when it goes down. The reverse is true if you purchase from the us but sell in Canada. If you purchase and sell in us dollars, there is very little risk because you will gain on one side and lose on the other.

If you have significant dollars tied up in foreign currency transactions, you may want to find more formal ways to minimize the risks. One way to do that is through hedging contracts. Hedging contracts allow you to purchase or sell foreign currencies at a specific time for a specific price.

Here's how they work: You are a us company selling product to Australia. You will be receiving Australian dollars in 60 days for a large shipment of goods. You are very concerned about the exchange rate trend lately, and you are worried that the Australian dollar will be worth less by the time you receive the payment. If so, you will get less value for the goods you shipped.

A hedging contract allows you to fix the price of the sale. Let's say that the Australian dollar is worth 0.617 to the us dollar. You have sold Aus$10,000 worth of product to a customer in Brisbane. At the date of sale, its value is $6,170 us. You set up your receivable for this amount. You are concerned that the Australian exchange rate will drop to 0.597 in 30 days, which is when you expect to receive payment. As a result, you would get only $5,970 worth of value. You would lose us$200 just for holding the receivable.

You would buy a foreign currency contract stipulating that you sell Aus$10,000 for 0.612 in 30 days. You would pay a premium to do this. Let's assume the premium costs you us$30. Here's what your cash flows look like, assuming the Australian dollar does go down to 0.597:

1. You pay a premium of us$30 for the hedging contract.

2. You receive the equivalent of $5,970 in 30 days from the customer. Therefore, you have an exchange loss on the sale of us$200.

3. You take the Aus$10,000 that you received from your customer and sell it per the contract at 0.612. You gain $150 on the transaction because you are selling something for the equivalent of $6,120 that's worth only $5,970 in the open market.

Looking at all these things together, you have lost $80 ($150­$200 - $30). Remember that had you not entered into the contract, you would have lost $200. Hedging foreign currency positions is a useful strategy that businesses of all sizes can use to reduce the risk of importing and exporting.