Manage importing risk with hedging and currency monitoring

At the beginning of the new year, importers plan international transactions and set profit goals. Medium-size companies tend to prepare for transactions two to four months in advance, while large companies usually plan five to eight months ahead.

Top management is usually involved in these plans. They consider all aspects of the transaction, from sales to engineering, manufacturing and purchasing, and ultimately, finances. Failure to adjust plans to currency trends can result in severe loss, or the whole project being abandoned due to lack of profitability.

Canadian importers should assess currencies’ influence on their bottom line at the moment they decide to import a foreign product. When the purchase order (P.O.) is issued to the foreign exporter, currency exchange risk begins to build. Currency exchange specialists often recommend two strategies to mitigate that risk:

1. Hedging
2. Currency monitoring

Importers paying for product in Canadian dollars should choose at least one strategy, or a combination of the two throughout the currency exchange risk period. The strategy should provide an attractive, financially reasonable cost-risk ratio.

Hedging

With hedging, the risk period ends at the moment the strategy is employed. The “safe haven” in hedging should start from the P.O. date and end at the payment date. When importers make payment to the exporter, they use hedge funds and the hedging strategy expires.

Despite myths to the contrary, the hedging scenario doesn’t completely eliminate currency exchange risk. Hedging doesn’t cover the time period when the product is awaiting sale to a domestic buyer, and that time period forms a significant risk to an unaware importer.

At the date of the product’s sale, the importer realizes a currency exchange loss or gain that has accumulated from the day of hedge expiration to the day of the product’s sale.

Currency monitoring

With currency monitoring, exchange risk starts to build when a decision is made to import the product. Like hedging, risk ends when the imported product is sold to a domestic buyer.

But the currency monitoring strategy starts earlier than hedging; when a decision is made to import product, and extends to the issuing of a P.O. In this time period, decisions are made regarding:

• When to issue the P.O., according to the overall importing goal and currency exchange risk for a particular currency pair.
• How to time and structure payments according to currency risk.
• How to negotiate payment schedules according to the financial environment of the exporter’s country.

When using the currency monitoring strategy, importers should structure information from a currency specialist into three significant stages covering the entire period of risk accumulation.

First stage

The first stage ranges from the decision to import foreign product, to the day of payment to the exporter. The first stage (and probably the most important stage within the monitoring strategy) lays the foundation for a successful price and payment negotiation, P.O. date and payment due date. The importer in the first stage of a currency monitoring strategy should receive:

• The currency pair’s evaluation and forecast, and risk evaluation.
• Payment forecast and confirmation of dates.
• Analysis of the fundamentals reflected in the currency pair—information used to prepare the negotiating team.

Second stage

The second stage covers the period from the payment date to the day imported product lands on Canadian soil. This stage should also include forecasts, followed by confirmed scheduling of possible partial late payments.

Confirmation of specific dates for payment allows the importer to progress into currency exchange gain. The importer should also receive fundamental updates from the exporter’s country on fiscal and economic news, along with weekly updates on the currency pair.

The currency specialist should warn the importer about any unpredicted developments or economic events in the exporter’s country that could affect payments.

Third stage

The third stage covers distribution and selling time. In this stage, the importer should continue to receive ordered updates with a special focus on the exchange rate at the date of sale to the Canadian buyer.

The exchange rate on the date of sale is used to calculate the currency exchange gain or loss. At that date, importers often realize ‘unfortunate’ currency exchange losses or a ‘well earned’ currency gain.

Ongoing updates in the third stage form an educational basis for the negotiating team to tackle the next contract with the same exporter, or a different exporter from the same country.

The currency monitoring strategy rewards the importer in the form of the best possible due dates for payment, a greater possibility of eliminating currency exchange loss, and exposure to potential currency exchange gain. The strategy also creates a knowledgeable and experienced importing team.

Effects of tapering

Importers are also staying tuned to recent developments in the US, when making decisions on transactions. We are living in historically important times, when today’s financial news influences our financial future for many years to come. The Federal Reserve (Fed) made a decision to announce financial tapering just a few days before Christmas.

The announcement caused minimal panic due to light trading during the pre-holiday season. The size of the tapering signals a cautious approach, but it also sends a crucial message: “we are watching, we are ready to act, and be prepared for more.”

At this point in time, I’d compare the current situation to the movement of a car. The car is still going in the same direction but the Fed has pressed the brakes to decelerate.

In my opinion, we’re moving slowly into period of high currency pair volatility. In my next article, I’ll analyze the influence of currency fluctuations over import/export profits.

Darek Wozniak is president of JW Investrade, a currency exchange consulting firm in London, Ont. He may be reached via email.