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Managing foreign currency exposure: Contractual agreements

Futurpreneur | November 8, 2011

Article series – Part 1 of 2

Mike Smith, derivatives lawyer, Montreal, QC, CYBF mentor

Whether you plan to manufacture or sell internationally, exchange rates will be an important factor in the decisions you make. The world markets are liquid, flexible and highly complex, and what seems like good business today may not actually be when there is a 40-point swing in exchange rates. With respect to the Canada-US exchange, between 2002 and today, the Canadian dollar has swung about 40 cents. That’s a big change!

There are various strategies to protect your business from currency swings in the short, middle, and long-term. The option you choose will depend on the level of sophistication of your business, the size of the transaction, the size of your business (Sales), and your own investment knowledge. This article (part 1) focuses on contractual arrangement strategies which are best suited to smaller companies, and part 2 looks at derivative-related strategies which work for medium-to-large companies.

Though these aren’t official terms, common types of agreements include:

  • A  Base Currency Agreement – Depending on the type of transaction and the power you have in the negotiations, you can artificially price a transaction in your preferred currency; placing the bulk of the risk on the other party. For example, if you sell a lot to the US, but are based in Canada (and all your costs are in Canadian), you can price only in Canadian dollars. This ensures you always know your costs and protects you from downside risk, but you lose the potential upside of a currency jump.
  • A Fixed Exchange Agreement – With each individual contract you can fix an exchange rate for the life of the contract. For example, building on the last example, the contract will be in US dollars, but the parties agree upon the exchange rate they will use to convert from US to CDN dollars. This splits the risk between the parties, as one will always win, and one will always lose.
  • A Capped/Straddle Agreement – The parties agree that they will mute the fluctuations within a certain range. In other words, there will be a floating rate matching the indices as long as it is inside a certain range. However, the exchange rate cannot surpass the upper limit so it becomes fixed there. In this case, one party wins and one party loses should currency move outside that range.

Derivatives offer other opportunities to manage foreign currency risk. To learn more, see Managing foreign currency exposure: Derivatives (part 2).

This is only a cursory overview of some of the hedging strategies you could take to protect your business. If you plan to use a hedging strategy, be sure to seek advice from an expert.