Economy

Balancing on a shaky buck

Written by ProfitGuide Staff

Congratulations! Your biggest American customer has just booked a US$4-million order for delivery in 90 days. If the Canadian dollar remains at US93¢, you’ll add a tidy C$4.3 million to your top line.

Not so fast. By delivery day, the loonie has jumped to US98¢, slashing your proceeds to C$4.08 million. You’re out C$220,000 — or a third of the profit you had anticipated on the deal.

Such a dramatic gain in the dollar’s value over a few months would have been unimaginable during most of the currency’s 151-year history. But these days, extreme swings in the loonie are routine. After the biggest run-up ever, the dollar’s value plummeted by 23% in the 17 months through March 2009, then soared by 16% in the following five months.

Colin Pyle, vice-president of Toronto-based EquityFX, a foreign-exchange broker, says that deep uncertainty about the global economy and ever-gyrating stock and commodity markets mean currency volatility is here to stay. That’s why, if you generate significant sales in other currencies, you need to take action to protect your firm against the loonie’s next surge.

Your best bet is a tactic that might seem like a game for big companies but not your firm: currency hedging. And it’s true that some forms of hedging are too complicated for most SMEs. But the simplest method, a forward contract, is neither complex nor pricey. In fact, says Pyle, “It’s an extremely cheap form of insurance.”

In a forward contract, you pay a bank or foreign exchange (forex) broker “forward points” to lock in today’s exchange rate for the date when you’ll get paid. For deals involving major currencies, says Pyle, you are likely to pay five to 10 basis points (a basis point is 1/100 of 1%) for every four to six weeks until you collect your receivable. In the above scenario, for a net cost of $5,000, you could have protected yourself against the $220,000 loss.

You can hedge even for modest transactions. Ron Rylott, director of business development for forex products at Toronto-based BMO Capital Markets, says you can book a forward contract online for a deal worth as little as $25,000.

There is a potential downside. Your forward-contract provider might ask you to put up collateral of 5% to 15% of the contract’s total value. However, Export Development Canada offers a program, the Foreign Exchange Facility Guarantee, in which it covers up to 30% of your collateral requirement. That’s usually enough to convince the bank or broker to forgo its demand for collateral.

The biggest limitation of arranging a forward contract is that it’s a one-way bet that the loonie will rise. If it were to drop by US5¢, you’d still get your $4.3 million. But, without a forward contract, you would have collected $4.55 million. Ouch!

If you think the Canuck buck is very likely headed higher, then a forward contract might suffice. Rylott says most players in the forex market think the dollar will soon achieve parity with the U.S. greenback or a little more — maybe even by the end of 2009.

Even if they’re right, what if the loonie then starts yet another slide? If you think the risks are substantial in either direction, consider another form of hedging: currency options. As with a forward contract, you can set one up with a bank or forex broker. The difference is that a currency option gives you the right, not the obligation, to sell the foreign currency to your provider on the date specified.

Protecting yourself against both upside and downside risk comes at a price. Pyle says that a provider would currently charge you about $100,000 on the US$4-million deal. If the loonie were to rise to US98¢, you would exercise the option to collect $4.3 million, sparing yourself the $220,000 loss from doing nothing. Subtract the cost of the option and you’d still be ahead by $120,000.

If the loonie instead fell to US88¢, you’d walk away from the option. You’d collect the full $4.55 million, for a net saving of $145,000 after paying for the option.

A currency option is far more complex to administer than a forward contract, and likely available only for deals starting at $250,000. Still, you might figure the added protection is worth it.

You could also explore with your forex provider a long list of more complicated currency options. Pyle advises splitting your business between, say, a bank and a forex broker — keeping each on its toes so you get the best rates and service.

Whichever method you pick, the crucial thing is to realize that it’s no longer prudent simply to hope for the best. Many entrepreneurs feel that it’s gambling if you’re hedging, says Rylott. “But the real gamble is doing nothing.”

Originally appeared on PROFITguide.com