Canadian Underwriter
Feature

Exchanging Risk


December 2, 2016   by Laura Bobak, Research and Communications Manager, Financial Executives International Canada and the Canadian Financial Executives Research Foundation


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There is a phenomenon among some companies that could be described as FX victim mentality. Some organizations with exposure to FX have simply done the corporate equivalent of throwing their hands in the air and letting fate take its course.

A recent study by the Canadian Financial Executives Research Foundation (CFERF), revealed that despite the upheaval in commodities prices and the volatile Canadian dollar, more than one in four Canadian financial executives surveyed have no foreign exchange (FX) risk management strategy in place and almost one-third have no plans to implement one anytime soon.

Yet, 66% of senior financial executives polled for the study, Exploring Foreign Exchange Enterprise Risk Management in Canada, rated FX risk management as important or extremely important to their companies. In addition, more than 60% reported it had become more critical in the past 12 months of volatility.

“It’s important to have a well thought out risk management plan in place, so that when the time comes, you already have that framework in place and execute accordingly in a systematic way,” says Laura Pacheco, vice president of research at CFERF, the research arm of Financial Executives International Canada.

The study, conducted in February and March, was based on the results of an online survey of 116 senior financial executives from across Canada.

Karl Schamotta, director of global product and market strategy – hedging solutions at Cambridge Global Payments, which sponsored the report, says leaving FX exposure to fate is a common approach among small to medium-sized enterprises (SMEs).

Findings show almost 20% of respondents from businesses with revenues between $25 million and $100 million did not even track FX exposure.

“People think that exchange rates mean revert. In other words, one year they are up and the next year they are down,” Schamotta says.

But that is not the case. “The clear lesson of the last decade and a half is that exchange rates could rise for five to 10 years in a row, and then fall precipitously. There is no such thing as an average exchange rate that you can use.”

Bank forecasts are the go-to resource for respondents when establishing FX rate budgets (61%), a strategy Schamotta says is ineffective, followed by implied forward rates (25%) and hedged rates (20%).

Many do not realize that there are strategies available even to SMEs that can be used to smooth out volatility.

VOLATILITY DRIVEN BY POLITICAL SHIFTS, DIVERGING INTEREST RATES

“Globally, we have got the return of political risk,” Schamotta says. “The major developed economies are acting like emerging economies,” he notes, adding the recent election in the United States and Brexit in the United Kingdom generated volatility. Upcoming triggers include elections and other major political events in Italy, the U.K., France and Germany.

“There is considerable uncertainty about the path of economic policy in these areas and unpredictability around the balance of power, trade and financial flows between countries,” Schamotta suggests.

This has been the case for Ajay Rao, chief financial officer (CFO) of Conros Corporation, a privately held manufacturer of shipping and office supplies in the Greater Toronto Area whose clients include the United States Postal Service.

“We have tried to naturally hedge by buying and selling in U.S. dollars. But when the business community reads that the Chinese currency is in trouble, there is an expectation on the part of retailers to pass on the benefit,” Rao says.

“To a certain extent, it’s not foreign exchange exposure that’s creating challenges, it’s a foreign exchange economic event that is impacting business – both payables and receivables,” he says.

In terms of Canada’s biggest trading partner, President-elect Donald Trump’s protectionist policies are seen as potentially raising prices in the U.S. and that is raising interest rates, Schamotta says, adding the U.S. dollar and economy are detaching from the pack and moving strongly ahead.

“We have a Canadian economy that is struggling to adapt to a changed world,” he argues. “We have depressed oil prices weighing on the Canadian dollar, with very little sign of a break,” Schamotta says.

Oversupply in the global market and a lacklustre demand for crude oil will likely keep the market balanced, he suggests. Interest rate differentials are also weighing on the Loonie, with the Bank of Canada not in a position to raise rates quickly, he says.

The Canadian dollar has moved by almost 30 cents in the last two and half years, and Canadian companies are struggling to adapt, not just to cash flow unpredictability, but also to challenges to their economic models as well, says Schamotta. “The sheer unpredictability of the situation is raising risk and it is making it difficult for businesses to plan,” he adds.

“We have seen a sharp uptick in emerging market volatility,” Schamotta says. “Costs are dropping throughout the supply chain, but Canadian companies selling into those areas are taking a pretty big hit right now.”

WHAT COMPANIES CAN DO

Given this grim landscape, many financial managers may feel there is not much they can do other than wait for conditions to improve. This is where the practices employed by large and small-to-medium companies differ, Schamotta says.

“That has big implications for how fast those smaller businesses can grow. If they continue to take that tactical or reactive approach, it will be difficult to catch up to companies in Canada, which have been deploying these strategies for a long time,” he notes.

Many CFOs will argue that they can barely keep their heads above water managing other issues such as financial reporting, debt financing, cash flow, tax planning and, in some cases, human resources and IT.

But managing FX is critical since it has an impact on those very same priorities. “FX should often be a higher priority than it is,” Schamotta contends, emphasizing that FX risk management needs to be a priority through the organization, not just for the finance team.

“A lot of people think they know foreign exchange, but they don’t,” Kenneth Kirk, chief financial officer of Sepro Mineral Systems Corp., said during a roundtable discussion. “We have many offices in a number of countries that operate in volatile currencies and they don’t have a clue about what impact the foreign exchange has on the company as a whole. So it’s really trying to keep them educated and make sure that as an organization you are re-emphasizing your foreign exchange position.”

Building a simple process for managing FX exposure and sticking to it allows organizations to avoid analyzing what has happened in the market from a day-to-day perspective, Schamotta says.

Once the process is broken down into simple steps, an organization can simply follow it. “Rather than throwing everything at the roulette wheel once a year, always running a process whenever you identify an exposure and hedging that relatively quickly is the secret to success.”

Paul Jewer, executive vice president and chief financial officer of heavy equipment vendor Toromont Industries Ltd., says his company’s input costs are in U.S. dollars and its products are priced in Canadian dollars. “The sharp movement has really led to sticker shock, which has caused some deferral,” Jewer says.

“The key question that we have to ask ourselves is: Are things going to improve vis-à-vis the strengthening Canadian dollar? When you’re sitting on $300 million worth of inventory, that’s a pretty big exposure,” he reports.

“For pure foreign exchange exposures, we try to eliminate all risks with rolling hedges and forward contracts,” he adds.

To effectively manage FX risk, every company should have a policy document that sets out the following:

  • how to analyze FX exposures;
  • strategy for dealing with exposures; and
  • how to execute strategy.

“For each of those stages, companies should map out procedures, time lines, vulnerabilities, any limits applicable to individuals or groups, and how things are going to be communicated throughout the organization,” Schamotta says.

When it comes to estimating exposure to exchange rate changes, almost two-thirds of survey respondents reported they rely on cash flow forecasts, 36% use sensitivity analysis and 24% employ historical estimates.

WHAT INSURERS SHOULD LOOK FOR

Schamotta recommends underwriters assessing the FX risk of a company look at stability of cash flows over the last couple of years. “If you see large swings and they are related to FX, then you know that there is a problem there. If they are running very stable cash flows, then perhaps there is not a lot of risk there,” he says.

“There is a huge segment of the Canadian corporate population that is not focusing much on managing FX exposure,” Schamotta reports. “They are thinking that the fates will blow the way the fates blow. They are not thinking that they can take control of the exposures that they have.”

Laura Bobak, Research and Communications Manager, Financial Executives International Canada and the Canadian Financial Executives Research Foundation