Ian: Welcome to the Business Coach Podcast, an advice-oriented series that tackles the hot issues and opportunities facing Canada’s small businesses. I’m your host, Ian Portsmouth, the Editor of PROFIT Magazine and we’ve developed this podcast in cooperation with BMO Bank of Montreal.
While the rise of the loonie is well received by some companies and totally despised by others, there is one thing that they can all agree on concerning international currency markets, volatility is the enemy of everyone. There is a way you can minimize currency risks if you are an importer or exporter and that’s by hedging.
Here to explain the art of currency hedging is Ron Rylott, Director of Business Development for Foreign Exchange Products at BMO Capital Markets. Ron thanks for joining the Business Coach.
Ron: Happy to help.
Ian: So, big big big big question. What is hedging?
Ron: Truly it is just a way to help companies mitigate possible losses or mitigate the risk of the currency moving in an unfavorable direction.
Ian: Now, to a certain degree, it’s a little bit of guess work because you’re hedging your bet says they say but you could still be betting on the wrong side of the equation. So why should people consider hedging strategies?
Ron: Actually, I disagree with your premise. I think that doing nothing is probably more risky than bringing some certainty to what the future holds. Really hedging just becomes a matter of turning an unacceptable risk into an acceptable one.
Ian: Got it. So, when should a company adopt a currency hedging strategy?
Ron: Ideally, many companies sit down at the first of the year and they go through a budget and make the budget at a certain exchange rate for the upcoming year and that’s an ideal time to sit down and think about a hedging strategy if you will. So that they can then base their cost on a known exchange rate. So ideally it’s done at the first of the year or perhaps prior to signing a major contract that has a foreign exchange component to it.
Ian: And how popular is hedging as a foreign exchange management tool?
Ron: I think it is becoming more recognized and certainly this year with the volatility that we have seen in the Canadian dollar. Companies are realizing that they have to do something. To be quite honest, I don’t think companies do enough. I think there is a great deal more that they could or should be doing but it’s certainly a prominence today because, you know, it’s in the papers, it’s on the radio, given the strength of the dollar this year.
Ian: Now there are numerous hedging strategies out there. What is a common one that you could explain how it works?
Ron: The most commonly used hedging vehicle is a forward contract. Forward contract is easy to understand and requires very little administration. A forward contract is simply your financial institution has the ability to make your price today for future delivery of a currency. A common misunderstanding with forward contracts is it’s the bank’s view on where the currency market is going and in fact it’s really just a function of interest rate and it’s the differential in interest between the two currencies that you’re hedging. To give you an example of what I mean by that, U.S. – Canada are certainly the most common two currencies that would see with our clients. Clients that are receiving U.S. dollars and subsequently selling them to their bank, a forward contract means that the value of their future receivable is greater than what the price they could get today. So they receive a premium over what today’s price is for their foreign exchange.
Ian: Are there any other common hedging strategies that are worth discussing?
Ron: Well the only other, really there are only two. Forward contracts again are the most commonly used but the next step up from that would be a currency option. Forward contract is an obligation to deliver at some point in the future, currency option is the right rather than the obligation to deliver. And how that can help clients is that rather than being locked in at a particular rate, an option provides them the right rather than that obligation so that if the market has moved in their favor, they would not exercise their option, instead they’d sell or buy on a spot basis and pick up the incremental gain. Naturally, that sounds too good to be true, so the other major difference between an option and a forward is that options come with a premium up front and forward contracts have no fees associated with them.
Ian: So how much does hedging cost?
Ron: Well, there are no cost associated with a forward contract. It is based, they’d received a premium or discount over what today’s price is, simply based on exchange rates. A currency option however, there is a number of factors that goes into the cost. Everything from the protection level they’re looking at to the length of the contract to market volatility. So it could be tens of thousands of dollars per million depending on a number of factors. So options tend to be seen as more expensive certainly.
Ian: And where should companies go if they want to adopt hedging strategies such as options and forward contracts? Can their typical big bank do it? Should they go to foreign exchange specialists?
Ron: I would suggest to them that they absolute best thing they can do is to speak to their banker. There are many tools available today. Typically an outside provider of foreign exchange is in business because they’re competing against a financial institution that’s pricing at a branch, pricing on foreign exchange is based on real time, they should be either dealing directly with a foreign exchange professional on a trading floor or possibly online if the volume of business they do is note enough to warrant hands-on professional advice. But every big bank today would have a trading floor that ideally clients would deal with if their volume of business warrants, otherwise a wonderful alternative is the internet today and we have an internet offering that allows clients to deal on both the spot and the forward basis.
Ian: Ron, thanks for deciphering currency hedging for the Business Coach.
Ron: My pleasure.
Ian: Ron Rylott is Director of Business Development, Foreign Exchange Products at BMO Capital Markets.
Well that’s it for another episode of the Business Coach Podcast. You can download other installments in the series from BMO.com, profitguide.com or iTunes. And as always, I would love to hear your feedback and suggestions for future topics. Send them to me at firstname.lastname@example.org.
Until next time, I am Ian Portsmouth, Editor at the PROFIT Magazine, wishing you continued success.