An example to illustrate the hedging of exchange rate risk

Assume that the current US-Canada exchange rate is US $0.80 per C $1 (Canadian dollar, CAD). Consider the following two examples.

1. An exporter in the United States sells high tech manufacturing equipment to a Canadian importer. The total amount of goods sold is 11 million Canadian dollars (CAD), to be received by the exporter one year from now.
2. An investor in the United States invests in one-year risk-free Canadian government bills that pay 10% annually. The US investor starts with US $8 million and exchanges the amount for C $10 million at the exchange indicated above. At the end of the year, the investor expects to receive C $11 million.

We use the two examples to illustrate the inherent risk when selling or investing abroad abroad. In terms of Canadian dollars, the prices for the manufacturing equipment may mean good profit. When the exchange rates move in the wrong way, the exporter may end up with a loss when the Canadian dollars are converted into US dollars. On the other hand, the risk-free government bills are risk-free investment for Canadian investors. But for US investors that have to convert the proceeds back into US dollars, the end result may be a loss. In this post, we use these two examples to illustrate the potential danger of exchange rate risk and discuss some of the ways to mitigate this risk.

In some sense, the two examples are one example. The exporter or investor will receive C $11 million in one year (the same cash flow made in the same currency and then converted back to the same domestic currency). Thus both examples are subject to the same dynamics inherent in the movement of exchange rates. Even though both business contracts are profitable in terms of Canadian dollars, when the exchange rates move in an adverse direction, the parties in both examples could potentially experience a loss. Thus both examples can be discussed as one example.

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The outcomes

This previous post shows how to infer from a movement of exchange rates to determine whether a domestic currency depreciates (gains in value) or depreciates (loses in value) against a foreign currency. Furthermore, when the domestic currency loses in value against a foreign currency, it is a favorable environment to export to that foreign country. Applying these ideas, we make the following observations. For both the exporter and the investor, the domestic currency = US dollars and the foreign currency = Canadian dollars.

Favorable outcome when receiving funds from abroad
• The appreciation of the foreign currency.
• The depreciation of the domestic currency.

Unfavorable outcome when receiving funds from abroad
• The appreciation of the domestic currency.
• The depreciation of the foreign currency.

When the favorable outcome happens, the exporter or the investor will make money in the domestic currency (USD). When the unfavorable outcome happens, the exporter or the investor will lose money in USD. Let’s see why.

First the favorable outcome. When you are going to receive an amount of the foreign currency and if the foreign currency gains in value (against your domestic currency), you are getting something that is more valuable than before. When the domestic currency loses value against the foreign currency, one unit of the foreign currency buys more units of the domestic currency. This means that the exporter or the investor is getting an extra return on the investment.

The unfavorable outcome. When the foreign currency loses in value against the domestic currency, you are getting something that is less valuable than before. When the domestic currency gains in value, one unit of the foreign currency will buy fewer units of the domestic currency. This has the effect of reducing the return of the investment when the foreign currency is converted into the domestic currency. If the swing in exchange rate is big enough, it will cause a loss in the domestic currency.

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Numerical examples

To reinforce the ideas discussed above, let’s look at the examples numerically. As mentioned at the beginning, the initial exchange rate is US $0.80 per C $1. Suppose that the exchange rate is US $0.9 = C $1 a year later. This means that the Canadian dollar has gained in value against the US dollar (1 Canadian dollar can now buy more US dollars). The Canadian fund to be received is now worth more in US dolalrs. The 11 million Canadian dollars are now $9.9 million US dollars. This amount is US $1.1 million over the US $8 million the investor spent in buying the Canadian bills. So this is a good outcome for the exporter or investor.

On the other hand, suppose that the exchange rate is US $0.7 = C $1 one year later. This means that the US dollar has gained in value against the Canadian dollar (1 Canadian dollar now buys less US dollars). So the Canadian fund to be received is worth less in US dolalrs. The 11 miilion Canadian dollars would only be worth US $7.7 million. This amount is US $1.1 million less than the US $8 million the investor spent in buying the Canadian bills. For the investor in Canadian government bills, this preprents a negative rate of return (investing US $8 million and receiving US $7.7 million a year later).

So fluctuation in exchange rates has real financial consequences for anyone who is involved in import/export or investing abroad. The example in this post highlights the risk when the receivables in the investment are in a foreign currency. Any exporter who received foreign funds for the goods that they sell will fear the appreciation of their domestic currency, equivalently the depreciation of the foreign currency. The same can be said for any investor who has to convert the foreign investment proceeds into their domestic currency.

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Ways to mitigate the exchange rate risk

The example illustrates that businesses that exports or imports goods and services and investors who invest internationally need to consider how to protect against adverse movements in exchange rates. Even a small variation in the exchange rate can result in a big financial loss.

One way to hedge the exchange rate risk is to use a forward contract. A foreign currency forward contract is a contract to buy or sell a specific amount of a currency at a fixed exchange rate at a specific time in the future.

If the exporter/investor worries that the Canadian dollar will depreciate in one year so that the Canadian dollars received will be worth less, they can hedge this risk by entering into a forward contract. Here’s how. At the time the export contract or investment contract is made, the exporter or investor would agree to sell 11 million Canadian dollars for US dollars at a fixed exchange rate (this is called the forward exchange rate) one year later. The counter party to the exporter/investor, usually a bank, will agree to buy 11 million Canadian dollars at the terms specified in the contract.

Suppose that the forward exchange rate is US $0.77 per Canadian dollar. When the exporter or investor receives the 11 million Canadian dollars a year later, he/she can exchange the Canadian dollars for 0.77 x 11 = 8.47 million US dollars. Entering into this forward contract has the effect of locking in a favorable exchange rate one year ahead of time.

If one year later, the exchange rate is US $0.70 per C $1 (the Canadian dollar has weakened since one Canadian dollar can buy fewer US dollars), then the exporter/investor will only get US $7.7 million if there is no forward contract. With the forward contract, the amount of US dollars the exporter/investor will receive will still be 8.47 million US dollars. This would be a happy outcome for the exporter/investor.

If the exchange swings the other way and if there is no forward contract, it would be a profitable scenario. However, the forward contract is legally binding. That means the exporter/investor will have to honor the forward exchange rate set at the beginning. For example, if one year later, the exchange rate is US $0.90 per C $1 (the Canadian dollar has strengthened since one Canadian dollar can buy more US dollars), the exporter/investor will not be able to realize the profit an has to honor the forward exchange rate of US $0.77 per C $1. The amount of US dollars received will still be $8.47 million.

There are other ways to hedge the same risk. For example, the exporter/investor can also enter into a foreign currency futures contract or buy a foreign currency option. Another possibility is to open a bank account denominated in the foreign currency that is received. In this particular example, the exporter/investor can open a bank account denominated in Canadian dollars (either in Canada or in the US). The Canadian funds can be deposited into such an account and then converted back to US dollars when the exchange rate is favorable. There are pros and cons for each option, and which method to use depends on the business needs of the exporter/investor.

We would like to point out that the basic working of futures contracts is similar to forward contracts. Both futures contract and forward contract allow people to buy or sell a specific type of asset at a given price at a specific time in the future. One important difference is that futures contracts are exchange-traded and thus are standardized contracts. On the other hand, forward contracts are private agreements between two parties and can be tailored to meet the unique or unusual requirements of the party seeking the contract. There are other differences but we will not discuss them here. Our purpose here is to give a basic illustration on how to hedge the exchange rate risk.

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What happens if the export proceeds are made in the domestic currency?

In the exporter example discussed here, suppose that the business agreement is for the exporter to receive the export proceeds in US dollars (the domestic currency of the exporter). Then the exchange rate risk is transferred from the exporter to the importer. The exporter will not worry about getting less US dollars when the exchange rate moves in the wrong way, since he/she will be paid in US dollars. The importer will have to exchange Canadian dollars into US dollars to pay for the imported goods. Then it is the importer who bears the exchange rate risk and finds ways to hedge the risk.

Previously, the payment dynamics is about receiving funds in a foreign currency. Now the importer has to make payments in a foreign currency (the US dollar in our example). The dynamics is opposite of what it is before.

Favorable outcome when making payments in a foreign currency
• The depreciation of the foreign currency.
• The appreciation of the domestic currency.

Unfavorable outcome when making payments in a foreign currency
• The depreciation of the domestic currency.
• The appreciation of the foreign currency.

In the same example discussed above, the importer will have to come up with US $8 million to pay for the imported goods. The domestic currency for the importer is the Canadian dollar and the foreign currency is the US dollar. The importer will fear that the US dollar will get stronger, in which case, he/she will have to come up with more Canadian dollars to buy the same amount of US dollars. To hedge this risk, the importer can, at the time the business deal is made, enter into a foreign currency forward contract to buy US $8 million at a fixed exchange rate one year later.

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Remarks

The hedging in the example discussed above will completely eliminate the exchange rate risk for the exporter/importer or investor. Such perfect hedging may not be possible in all circumstances. In the above example, we know the exact amount of foreign currency to be received or paid. We are also certain of the timing of the payments. We also have the certainty of the payments – the investment is in risk-free bonds for example. If the investment is not in risk-free bonds but is instead in risky Canadian equity, we would know neither the ultimate values in Canadian dollars of the Canadian equity nor how many Canadian dollars to sell forward one year later. In the exporter/importer example above, we assume that there is no credit risk – that is, payments will always be made at the appointed time. If that is not the case, the hedging tool of the forward contract will not be effective.

The risk-free interest rate of 10% in the Canadian government bills in the above example is probably not a realistic rate. Currently both US and Canada are low interest rate environments. Both countries are well functioning economies and the exchange rate movements between US and Canada are typically not volatile. So the example here is only meant to serve the purpose of illustrating the hedging of exchange rate risk. However, if a US exporter is exporting to Russia or Venezuela, then the exporter will likely to demand payments be made in US dollars.

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