Managing an exposure, not taking a view
Hedging starts with an exposure the business already has or expects to have: a receivable, a payable, a forecast of sales or costs in another currency. A hedge offsets the effect of exchange rate movements on that exposure. A currency position taken without an underlying exposure, or larger than it, is a view on the market. It may be legitimate for some organizations, but it is a different activity with different risks, and it is not what this guide describes.
The examples below follow a Canadian business that receives US dollars and converts them to Canadian dollars. Rates are quoted as USD/CAD, the number of Canadian dollars for one US dollar, so a higher rate is better for this business.
Spot: conversion for settlement now
A spot transaction exchanges one currency for another at the current rate, for settlement usually within one or two business days, depending on the currencies. It is the right tool for money that needs converting now.
Spot is not free. The rate includes a spread between the price to buy and the price to sell, and payment or transaction fees can apply. Comparing providers on spot means comparing the rate received, not only the stated fee.
Spot also gives no protection to an exposure that is still open. A business that invoices a customer and plans to convert at spot when paid carries the full currency risk until the money arrives.
A Canadian exporter invoices $500,000 USD on 60 day terms and plans to convert when paid.
- Paid when USD/CAD is 1.3700$685,000 CAD
- Paid when USD/CAD is 1.3400$670,000 CAD
- Difference from the same invoice$15,000 CAD
Nothing about the sale changed. The difference comes entirely from the rate on the day of payment.
Forward contracts: a rate fixed for a future date
A forward contract fixes today the rate for an exchange of an agreed amount on a future date, or within a future window. Both sides are bound: the business must deliver the currency it sold and take the currency it bought, whatever the market rate is on the day.
The forward rate is not a forecast. It is the spot rate adjusted for the difference between the interest rates of the two currencies over the term, plus the provider's spread. A forward gives certainty for a known cash flow. What it gives up is any benefit if the rate moves in the business's favour, and it needs a credit facility with the provider.
FX options: protection with participation
An FX option gives the right, but not the obligation, to exchange at an agreed rate, the strike, on the expiry date. A Canadian exporter selling US dollars would buy an option to sell US dollars at the strike. If the rate at expiry is below the strike, the exporter exercises and sells at the strike. If it is above, the exporter lets the option lapse and sells at the better market rate.
That flexibility has a price: the premium, paid upfront, which depends on the strike, the term, market volatility and interest rates. Structures that reduce or remove the upfront premium carry their cost in other ways, such as a cap on the benefit or an obligation to exchange. The FX options guide explains these.
The three compared
| Feature | Spot | Forward | Vanilla option |
|---|---|---|---|
| Primary purpose | Convert currency needed now | Fix the rate for a known future cash flow | Set a protected rate while keeping the benefit of favourable moves |
| Rate certainty | Only for the amount converted today | Full, for the agreed amount and date | A known worst rate: the strike, adjusted for the premium |
| Favourable moves | None once converted; before conversion the exposure is fully open | None | Full participation, less the premium |
| Upfront premium | None. The rate includes a spread, and fees may apply | None. The rate includes forward points and a spread | Yes, set by strike, term, volatility and interest rates |
| Flexibility | Complete, with no protection | Low: the contract must be settled. Window and open forwards add flexibility on timing | High: exercise is a right, not an obligation |
| What it gives up | Protection | The benefit of favourable moves | The premium |
| Typical corporate use | Payments and receipts due now | Committed receivables and payables; protecting a budget rate | Exposures uncertain in amount or timing, such as tenders and forecasts |
Choosing between them
The right tool depends on the exposure, not on which alternative looks cheapest at first glance. A few questions usually settle it:
- How certain is the cash flow? A signed contract or an issued invoice suits a forward. A forecast that may not happen, or may be smaller, suits a smaller forward hedge, an option, or both.
- How sensitive is the margin? The thinner the margin, the more value certainty has.
- What can the business accept? A premium paid upfront, a cap on gains, or an obligation to exchange. Each tool asks for one of these.
- What does the policy permit? Instruments, tenors and approval levels should be set out before the decision, not during it.
Many businesses combine tools: forwards for committed exposure, and options or a smaller forward hedge for the part of a forecast that is less certain. A comparison that looks only at the headline rate or premium misses the point. The question is how each alternative behaves across the rates the business could face, and which of those outcomes it can live with.
This article is general information about managing currency risk. It is not investment advice or a recommendation to use any instrument, and examples use illustrative rates and amounts, not quotations. Products are offered in Canada by Vantry Capital Inc., subject to eligibility and credit approval.