Reduce risk via operational hedging
Exchange rates play an important role in determining corporate profitability and competitiveness. The current strength of the Canadian dollar poses unique risks and opportunities for Canadian companies with global supply chains and those who sell in many geographic markets.
Specifically, firms must manage having their revenues denominated in Canadian dollars and their costs denominated in other currencies. Exchange rate fluctuations, specifically a steep fall in the loonie, will introduce significant variability in costs and revenues potentially wreaking havoc on profitability, competitiveness and shareholder value.
While there are solid benefits to a strong dollar (e.g. stronger purchasing power), there are also compelling financial and strategic risks around a rapid and sustained fall in the loonie. Managers would be wise to pursue a more holistic and longer-term approach to risk management, with particular attention paid to operational strategies.
The loonie is at a record high versus key foreign currencies. Canada’s dollar traded stronger than parity with its U.S counterpart on average this year for the first time in three decades. The currency averaged 98.92¢ per U.S. dollar in 2011 – the highest annual value since 1976 when it traded at US.63¢. The loonie’s relative value against the greenback is vital to almost every company as the U.S. is by far Canada’s largest trading partner.
Furthermore, the loonie is overvalued against other key currencies. For example, Canada’s dollar had its strongest annual close against the euro since the shared currency began trading in 1999. Is a strong loonie sustainable in the long term? Not likely. According to the IMF, the loonie is will be 20% overvalued versus the greenback on a purchasing power-parity basis. The larger the overvaluation and the longer it is sustained, the greater the business risk.
A rapidly falling loonie will have serious implications for Canadian firms with outsourced production including higher input (raw material, labour and transportation) costs, a potential loss of domestic market share versus domestic producers and eroding profit margins. There are many macro-economic and political reasons why the loonie could drop quickly and precipitously.
Ongoing uncertainty around the European debt crisis as well as a slowdown in Chinese growth may dampen the global economy and demand for the commodity-driven loonie. Canadian fiscal performance may hit the skids plus there remains the potential for falling interest rate spreads versus the U.S. Finally, continued political instability in the Middle East and Asia threatens to create instability in the currency markets. Canada is a relatively small currency market and is not a safe haven for international investors in times of turmoil. When fear grips markets, flight-to-safety flows hurt the loonie.
The impact of a long-term fall in the dollar’s value and the associated exchange-rate risk is not only limited to short-term financial exposure. In an integrated global economy, companies face strong interdependencies across their risk categories – strategic risks, operational risks, financial risks and external risks – which can quickly degrade their competitive position, limit decision-making flexibility and shrink operating margins.
Traditional financial hedging tools, designed to smooth out short-term cash flows, are often insufficient or too expensive to address large and sustained exchange rate shifts. To effectively manage these longer-term risks, companies should employ “operational hedging.”
Operational hedging is a holistic risk-management approach that allows for greater flexibility in how supply chains, product distribution patterns and market-facing activities are designed and changed. Managers would use operational hedging strategies in conjunction with financial hedging to pre-empt or mitigate the effects of a large, exchange rate-triggered change in their cost structure, customer demand and competitiveness. Typical operational hedging strategies could involve revamping a firm’s supply chains, go-to-market program and purchasing strategies based on their unique business model and market environment.
Firms should approach operational hedging in a systematic fashion by: determining the vulnerable areas in the business (i.e. the cost and revenue drivers that are most impacted by large exchange-rate swings); considering various scenarios for currency-related risk impact (e.g. using multiple exchange rates over different periods); perform a sensitivity analysis on these drivers to determine the total business impact; and adopting operational hedging as a foundational risk-management strategy. In terms of operational hedging, strategic choices could involve evaluating the location of production facilities, sources of raw materials, pricing strategies, logistics networks, and how sales and marketing channels by geography are organized.
When deployed proactively and carefully, operational hedging can be a powerful tool to minimize the impact of major currency shifts on costs and revenues, while enabling firms to potentially leapfrog less-agile competitors. Managers need to be mindful that a proper operational hedging strategy may require significant time and investment to implement, whereas a steep decline in the dollar’s value could erode operating margins and competitive positions rapidly.
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