Just how high can the dollar go?
According to Bank Credit Analyst, a well-respected economic-consulting firm in Montreal, the Canadian dollar could top out at US90Ãâ.
If you export to the U.S., that’s a dire piece of news. If you’re an importer, you couldn’t be happier — but the loonie could dip many times along the way. Luckily, there are any number of business strategies, from cost-cutting to productivity improvements, that can ease the pain of a stronger loonie over the long term. And if you want to smooth out the bumps along the way, you can turn to currency hedging.
Evan Steed, a currency and options trader with BMO Nesbitt Burns, says the recent currency fluctuations have led to an uptick in the number of Canadian firms looking to lock in the future value of current contracts through currency hedging. “The same way you buy fire insurance on a factory,” says Steed, “many are buying insurance on their cash flows.”
Hedging requires managers first to evaluate the risk to your firm of a dropping greenback relative to the loonie. “At what point is it unprofitable for you to do business? Is it a Canadian dollar at 1.20 or 1.30?” That’s the value you will want to consider when locking in an exchange rate through hedging.
Most common in Canada are forward contracts. Offered by banks, they contract you to buy a set number of dollars at a predetermined price on a strike date of your choosing. “Forward contracts that hedge against a fall in the loonie are the classic Canadian hedge,” says Steed. “But now we’re seeing mirror contracts to reflect the increase in the dollar.”
Forward contracts are fairly simple. Let’s look at the example of a Canadian supplier whose U.S. client will be paying in U.S. dollars for completion of a contract or delivery of a product one year from now. Should the value of the U.S. dollar drop by 10% against the loonie over the next year, the exporter essentially suffers a 10% discount on its price when the payment is converted into Canadian dollars.
But by signing a forward contract you sign a deal with the bank to pay you an agreed upon rate for those U.S. dollars a year from now (in other words, sell you Canadian dollars at a set rate). So, for instance, if your contract locks in the purchase at today’s exchange rate and the U.S. dollar does drop in value, you’ll be none the worse.
Of course, such peace of mind doesn’t come free. The bank will charge you for the privilege, but it’s a small price to pay when your operating currency makes a large swing. (For current forward contract rates, visit http://fx.sauder.ubc.ca/CAD/forward.html.)
There are alternatives. One involves options, which give you the right, but not the obligation, to buy or sell a currency as you would with a forward contract. An option offers some flexibility in that you can exercise it at its strike date or sell it into the spot market.
The final option, so to speak, is to do nothing and let the market take its course, a decision that Stead suggests is still taking a position on the direction of the currency. Only you can decide whether it’s worth the risk.
© 2004 Jeff Sanford
