What FX risk is
A business has a currency exposure whenever its revenues, costs, assets or liabilities are in a currency other than the one it reports in, its functional currency. For a Canadian business this often means US dollars, euros or sterling across sales, purchasing, financing or foreign operations.
Currency movements are not inherently bad. The same move that hurts an importer helps an exporter, and a weaker home currency can lift reported revenue. The risk is the uncertainty: when a margin, a price or a forecast depends on a rate nobody can know in advance, the exposure becomes a business risk rather than a market variable.
The three forms of currency exposure
Transaction exposure
Transaction exposure arises from a committed foreign currency cash flow that has not yet settled: an invoice issued, a purchase order placed, a contract signed. Between commitment and settlement, the home currency value of the transaction moves with the rate.
A Canadian distributor buys $250,000 USD of inventory on 60 day terms when USD/CAD is 1.3500, expecting a cost of $337,500 CAD. If the rate is 1.3900 when the invoice is paid, the cost is $347,500 CAD. The inventory has not changed, but it costs $10,000 CAD more.
Translation exposure
Translation exposure arises when the financial statements of a foreign operation, or foreign currency balances, are converted into the reporting currency. A Canadian parent whose US subsidiary has net assets of $10,000,000 USD reports $300,000 CAD less in net assets if USD/CAD falls from 1.3500 to 1.3200, without a dollar changing hands. Under IFRS, translation differences on a foreign operation generally go to other comprehensive income rather than profit, while foreign currency balances held by the business itself are revalued through profit. Translation affects reported equity, ratios and covenants, so it matters even when it does not touch cash.
Economic exposure
Economic exposure is the longer term effect of exchange rates on a business's competitive position, even where it has no foreign currency transactions. A Canadian furniture maker selling only in Canada competes with US imports. If the Canadian dollar strengthens, imports become cheaper in Canadian dollars and the maker's prices come under pressure, although it never invoices or pays in US dollars.
| Exposure | Arises from | Mainly affects | Usual response |
|---|---|---|---|
| Transaction | Committed receivables and payables, and forecast transactions | Cash flow and margin | Forwards and options matched to the cash flows, under a hedging policy |
| Translation | Foreign operations and foreign currency balances | Reported equity, earnings and ratios | A policy decision; often managed through financing in the same currency, and sometimes hedged |
| Economic | Competitors, customers and suppliers in other currencies | Pricing power and market share over years | Commercial choices: pricing, sourcing, location and currency of contracts |
How currency movements reach the business
- Gross margins. Prices fixed in one currency and costs in another leave the margin to the rate.
- Cash flows. The home currency amount received or paid on each settlement changes with the rate on the day.
- Forecast accuracy. A plan built at one rate and delivered at another produces variances that have nothing to do with operations.
- Financial statements. Revaluation of balances and translation of foreign operations move reported earnings and equity.
- Competitive pricing. A sustained move changes what customers can buy elsewhere, and at what price.
How quickly a margin can go
A Canadian exporter sells $1,000,000 USD of product a quarter. Its costs are $1,250,000 CAD, and its plan assumes USD/CAD of 1.3600.
- Revenue at 1.3600$1,360,000 CAD
- Margin at 1.3600$110,000 CAD (8.1%)
- Revenue if the rate falls 3%, to 1.3192$1,319,200 CAD
- Margin at 1.3192$69,200 CAD
- Share of the margin lost to a 3% move37%
At 1.2500, about 8% below plan, the margin is gone entirely. The thinner the margin, the larger the share of it a given currency move can take.
Matching the response to the exposure
Each form of exposure calls for a different response. Transaction exposure is the most direct to manage: amounts and dates are known, and forwards or options can be matched to them. Translation exposure is a reporting question first, and many businesses choose not to hedge it, or manage it by borrowing in the same currency as the foreign assets. Economic exposure is addressed mainly through commercial decisions, since no financial hedge lasts as long as a competitive shift.
Not every exposure needs a hedge. Some are small, some are offset by flows in the same currency, and some are better reduced at source by changing the currency of a contract or the timing of a payment. The starting point is to know where each exposure is, how large it is and when it will settle.
When currency risk becomes a priority
Currency management usually moves from occasional to deliberate when:
- International revenues or costs become a material share of the business
- Payment terms or contract periods extend beyond a few weeks
- Margins are thin enough for a few percent of currency movement to matter
- Forecasts start missing because of the rate rather than the operations
- Boards, lenders or auditors begin asking how the exposure is managed
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.