The surge in the Canadian dollar to a recent 11-year high of US 82 cents, and predictions that it could climb to 85 cents or even higher, is bad news for small- and medium-size Canadian technology vendors.
Most set the prices of their products in US dollars but pay their costs — such
as rent and employees’ salaries — in Canadian dollars. And unlike many larger organizations, they can’t pass the costs on to their customers.
For FinancialCAD Corporation, a Surrey, B.C.-based software developer, the 2003 rise in the Canadian dollar meant that every US dollar the company earned in revenues bought 17 per cent fewer Canadian dollars — the ones we pay our expenses in — just a few months later.
Like all Canadian SME tech vendors, FinancialCAD was hurt by the dollar’s rise. Unlike most of them, however, FinancialCAD protected itself, and continues to protect itself, from the worst of the damage caused by the upward moving Canadian dollar with a financial strategy that is simple but overlooked by most SMEs — ‘forward hedging’ on the dollar.
Here is how hedging works:
Suppose you’ve forecast your revenues to be US$5 million this year. And suppose you think the Canadian dollar will increase compared to the current value of US 82 cents and might go as high as 85 cents by the end of the year.
So you agree today to sell your bank US$5 million at the current rate of US82 cents later in the year. If the Canadian dollar goes above that, your revenues will still be worth what they are today.
Hedging slows the loss in purchasing power of your US-dollar revenues and gives you time to adjust to the higher exchange rate. Most importantly, hedging makes revenues and expenses stable and predictable, enabling management to make plans knowing it won’t have to change them if the dollar suddenly goes haywire.
Using forward contracts is not about betting on exchange rates; it’s about creating some certainty around future cash flows. By locking in a future exchange rate now, you lock in the margin you’ll earn on export business in the future.
FinancialCAD practices forward hedging because it understands its benefits. The company develops software that giant organizations, such as Coca-Cola, Levi Strauss, Microsoft, IBM, McDonalds and hundreds of others in over 60 countries, use to manage their hedging and other financial transactions.
These financial instruments, called derivatives, aren’t traded on public financial markets, and, therefore, don’t come with a price tag attached. FinancialCAD’s software lets financial and other organizations calculate their values and manage the risk of owning them.
The threat of exchange rate volatility always hangs over Canadian industry, says Werner Knittel, Vancouver-based vice-president of the Canadian Manufacturers and Exporters Association.
“”About 87 percent of Canadian exports go to the U.S.,”” Knittel says. “”Therefore, almost all Canadian exports are priced in US dollars.””
Manufacturers that can’t pass on increased costs as higher prices are especially vulnerable to a rising exchange rate. “”If their customers are price-sensitive, or much bigger than them, they’re in a tough spot,”” Knittel says.
Although using forwards is simple — you can order a forward contract on-line or over the telephone — it isn’t for the financial neophyte.
“”You need to know where to start,”” says Andrew Hung, commercial account manager at BMO in Vancouver. “”You’ve got to have at least a basic understanding of foreign exchange rates and how a change can affect you. You don’t need to know much, but you need to know that.””
If you enter into a forward contract, you need to put down a refundable cash deposit of about 10 percent in an interest-bearing account. In other words, you must be able to afford to not have access to hundreds of thousands of dollars for the duration of the contract. Hedging, therefore, is not a good strategy for start-ups or other companies that are unable to forecast the value and timing of their revenues and expenses.
There are two major risks to using forward contracts. First, since a forward is a commitment to buy one currency by paying for it with another, you must have the foreign currency that you are obligated to pay on the settlement date. If you don’t, you’ll have to buy it.
Second, if the Canadian dollar declines below the rate in the forward contract, you still only get the agreed-upon rate. This means you might not get the best rate available that day. You give up possible speculative gains in return for knowing in advance the rate you will get.
By operating a well thought-out hedging program, you eliminate the peaks and valleys in the exchange rate over time, but you don’t necessarily get the best rates. If you can predict the future, you don’t need forward contracts. If you can’t, you should look into forwards today.
Bob Park is president of FinancialCAD Corporation, a Surrey, B.C.-based technology company providing software and services that support the valuation and risk management of financial securities and derivatives.