If you do business across borders, you may need to send or receive payments in US dollars or other foreign currencies. If you do so, it is useful to manage foreign exchange risk: the risk that an exchange rate will swing in a way that disadvantages you before you make an upcoming payment (or receive an amount owing) in the foreign currency. For example, if you’re a Canadian business specializing in importing fabrics from India, and you pay your suppliers large sums in Indian rupees, then you should consider managing the risk associated with fluctuation of the dollar against the rupee.
There are a number of techniques for managing currency risk. Generally, they are all considered to be “hedging” techniques.
Hedging can sound like a complicated investment term, but at its essence, it really just refers to the idea of insuring yourself against potential negative outcomes. You insure your car so you’ll have some financial protection in the event of an accident. Having insurance doesn’t prevent an accident, but it reduces the financial impact on you if one happens. Similarly, in investing and FX trading, hedging is a way of “insuring” yourself against adverse events in the markets by reducing your exposure to a variety of financial risks. However, unlike simply purchasing car insurance, hedging is slightly more complicated, and requires you to make strategic investments designed to offset the risk of other investments or price movements.
When the Canadian dollar falls in value, importers worry they’ll be squeezed by increasing costs. If demand for their product seems fragile, some businesses will absorb the cost of currency depreciation rather than risk passing it on to customers.
But business owners can protect themselves by using forward contracts. Simply put, a forward contract is an agreement you make to buy a certain currency at an agreed exchange rate at a set future date. By making this agreement, you hedge your foreign currency exposure against future exchange rate volatility.
Forward transactions are often the cornerstone of foreign exchange hedging strategies for businesses of all sizes because they are flexible and easily customized. A forward contract lets you lock in a rate today for settlement at a future point in time, and it can be booked for any amount of foreign currency and any expiry date within six months. After you’ve locked in a forward contract, you have protection from exchange rate swings that can negatively affect you. Your forward contract guarantees your ability to buy or sell a foreign currency at your specified price by the expiry date, no matter what the market does.
As promising as this sounds, there is often no need to jump into the forward market with 100 percent of the funds in question. It is perfectly okay to trade partly in spot and partly in the forward market to avoid having all of your eggs in one basket, so to speak. It’s a good idea to speak to a Vancity Community Investment Bank Account Manager about this before you make a decision, especially if you’re new to the FX market.
Types of forward contracts
- A fixed dated (outright/closed) forward contract sets an exchange rate today for a currency pair transaction that will occur at a defined future date.
- An option-dated (open) forward contract, also known as a “window contract,” sets an exchange rate today for a currency trade that will occur in the future between an established start date (usually the next business day) and an expiry date (up to three months later).
Investors use forward contracts when they are unsure of what the market will do.
When to use forward contracts
Here are a few sample situations where forward contracts might be recommended:
- You’re not sure when you’ll need to pay for a product you received.
- You’re expecting payment in foreign currency for a product you delivered, but aren’t sure when it will arrive.
- You have accounts payable in foreign currency over the next several months, and see an opportunity to take advantage of current rates in the forward market.
- You have several contract dates for payment, but want to lock in a fixed rate for your product to sell in Canada.
A take-profit order lets you specify the exact rate at which to sell through a spot or forward trade that will realize a profit. Once the currency pair position rises to that specified exchange rate, the order is executed and your profits realized.
A stop loss order protects you from losses. As opposed to a take profit order, a stop loss lets you lock in your least favorable exchange rate in case the market moves against you. Vancity Community Investment Bank Account Managers monitor the market 24 hours a day, 5.5 days a week, and automatically locks in the stop loss exchange rate set if needed.
Order cancels order
An “order cancels other” (OCO) combines a pair of orders—usually take-profit and stop-loss orders—and automatically cancels one if the other is executed. This protects you against any risk of your order being double booked.