Natural hedging mitigates currency exchange risk

The most popular method to mitigate currency exchange risk is the simple “natural hedge.”

This is when an exporter and importer complete a transaction in the same currency; or when a company’s import and export transactions are completed in the same currency.

From a Canadian point of view, the US dollar (USD) is the most common currency in most natural hedges. For a natural hedge to take place, an American importer pays a Canadian exporter in USD.

The Canadian exporter deposits the funds in its USD account in a Canadian Bank, or a US branch of a Canadian bank. In cases where the Canadian exporter has an operation in the U.S., and this branch acts as an American importer, the USD funds are usually deposited in an American Bank.

When a Canadian manufacturer and exporter with a USD business account wishes to import product from the US, it uses USD funds to pay the American exporter. This way, the Canadian manufacturer avoids currency exchange.

Major Canadian banks offer business accounts in many foreign currencies, including: Euro, British Pound, Australian dollar, Swiss Franc, Danish Kroner, Hong Kong dollar, Japanese Yen, Mexican Peso, Norwegian Kroner, New Zealand dollar, Swedish Kroner and South African Rand.

Keep in mind that a natural hedge only mitigates currency exchange risk when the company uses the same foreign currency in both export and import transactions.

In other words, the company has to be able to export to and import products from the country where this particular foreign currency is a national currency.

The U.S. dollar serves as the sole exception to this rule, since exporters in most countries accept payments in USD.

Canadian exporters using natural hedge don’t completely escape currency exchange risk, however. The natural hedge only restricts the risk.

If the Canadian exporter isn’t able to cover the cost of its national operation from sales generated within Canada, it has to use funds from its USD business account to cover the difference.

And once you exchange U.S. funds into Canadian funds, you are exposed to currency exchange risk.

Long-term USD/CAD currency monitoring is crucial for such exchange transactions, which should occur at the peak value against the Canadian dollar.

The monitoring period should begin on the day the Canadian exporter realizes the need to exchange USD funds into CAD funds, and end past the due date for the currency exchange transaction. It’s a good policy to place the end of the first monitoring period closer to the date the Canadian exporter will make the decision for the second currency exchange of USD funds into CAD funds.

Subsidiaries of US, Chinese, British and European companies operating in Canada should be allowed to use a natural hedge in their financial transactions since it eliminates risk in their international transactions. Currency monitoring improves the profit of the Canadian subsidiary and won’t change the value of any international transaction.

The Canadian subsidiary may have to adjust payment terms with the parent company due to trends noticed during currency monitoring. In this business environment, currency fluctuations are much larger than current interest rates, and these fluctuations span much shorter time periods, amplifying the change in comparison to annual interest rates.

Related: Global tensions driving up US dollar

Darek Wozniak is president of JW Investrade, a currency exchange consulting firm in London, Ont. He may be reached via email.
Watch for Darek’s next article, focusing on currency pairs and the importance of foreign exchange markets to exporters and importers’ bottom line.