Controlling currency volatility

By Mark Borkowski | August 1, 2010 | Last updated on August 1, 2010
6 min read

Clients often want their advisors to be proactive, but foreign exchange is an issue most advisors are reactive about.

Currency volatility continues to impact the bottom line of owner-operated businesses as well as their portfolio investments. Moreover, currency volatility hides the high margins banks generate on foreign-exchange transactions, whether from small businesses paying invoices in U.S. dollars or euros, or from investors buying stocks in different currencies.

Rahim Madhavji, president of Knightsbridge Foreign Exchange, believes the time for accepting rampant currency volatility and high currency margins is over. There are simple tools businesses and advisors can use to minimize this risk and validate their FX pricing. Businesses can now plan ahead without having to worry about how the U.S. dollar or euro will impact their profit margins. Further, comparing FX rates in real time with an FX company can quickly identify methods to improve a client’s bottom line or investment returns.

While banks continue to proactively service large institutions, corporate foreign-exchange companies focus specifically on small- and medium-sized businesses and private clients such as portfolio managers and Florida property purchasers. These companies generally offer better-than-bank FX rates for spot transactions, as well as proactive hedging services that allow clients to lock in a rate today for a predetermined time in the future. “Many businesses are invoiced today in U.S. dollars, but aren’t required to pay for products until they’re delivered months later,” Madhavji explains. In that time, the exchange rate could take a dramatic turn for the worse, exposing the company to losses. The impact on cash flows could consequently affect the ability to repay bank debt as well as pay shareholders.

For this reason, Madhavji suggests businesses consider hedging their predictable currency requirements to protect cash flows. Similarly, “investors buying stocks in U.S. dollars are exposed to the performance of the underlying asset as well as the change in exchange rates; thus advisors need to evaluate if they’re taking views on both or if they want to eliminate the foreign exchange risk.”

Improve the bottom line

The Big Five banks have a stronghold on the corporate foreign-exchange market, with high currency margins of up to 2.5% hidden within the FX rate. This has set the stage for the entry of independent providers who can arrange for more competitive pricing and proactive service.

FX companies can generally offer more competitive rates because they buy in bulk and can thus negotiate better terms with the big banks.

For example, the real U.S./Canadian dollar exchange rate may be 1.060, but the bank’s advertised rate for a small- or medium-sized business may be closer to 1.080 or 1.085. An FX company, in comparison, would aggregate a bulk group of clients wishing to purchase U.S. dollars, and accordingly negotiate a better rate – say, 1.070 – based on higher purchasing power. It would then pass on some of the savings to those clients. Advisors can help business-owner clients realize these savings by investigating the FX pricing their clients currently receive. A small improvement in the FX rate of 0.005 for a business importing inventory of US$250,000 every month would result in savings of $15,000 per year!

Alternatively, instead of buying a U.S. stock with Canadian dollar funds directly, those funds can be converted into U.S. dollars more efficiently with an FX company, thereby eliminating banks’ high currency margins, which are hidden within the FX rate each time a stock is bought and sold.

Risk management

In addition to better pricing, there are a couple of things an advisor can do to protect his or her clients from future foreign-exchange volatility.

The most common tool is a forward contract, which allows a client to lock in an exchange rate today for use at a predetermined date in the future. For example, a machinery importer could lock in an exchange rate of CDN$1.03/US$1.00 today for three months, and can therefore fix its U.S. inventory cost and know the price it should sell its products for in Canada.

The buyer of this forward contract would agree to purchase a certain amount of U.S. dollars at a predetermined FX rate for a time in the future. The seller of the forward contract (the FX company) would then find a seller of U.S. dollars (usually a big bank), matching the buyer and the seller and making money on the spread – much like a stockbroker makes the spread between the bid and ask prices when matching a buyer and seller of a given stock.

There’s no additional fee for this product other than adjusting today’s exchange rate to reflect the time value of money between now and the maturity of the forward contract. However, there is an initial deposit (normally in the range of 5%-10% of the total amount of the intended purchase) to ensure the buyer does not renege on the contract. When the contract comes due, the deposit is credited against the dollar amount of the forward contract.

Pros and Cons

Essentially, a forward contract removes the element of risk associated with future foreign currency requirements: if the exchange rate moves unfavourably, the business isn’t impacted.

On the other hand, the primary downside of a forward contract is that it doesn’t allow participation in the upside movements in the exchange rate. However, for many business owners, the prospect of being able to fix costs and accurately plan ahead can outweigh that risk.

So, the question an advisor must ask a client is, do you want cost certainty, or do you want to take a chance with the FX market?

  • Mark Borkowski , is president of Mercantile Mergers & Acquisitions Corporation.

    Getting The Best FX Rates On Wire Transfers?

    While foreign exchange may not be core to a business, advisors should be aware of the hidden costs of foreign exchange that can impact a client’s bottom line. Validating the FX rates a business is getting every so often ensures a business-owner client is not being taken advantage of. Take the following example: An e-commerce communication firm sends US$500,000 worth of wire transfers every month to the U.S. Since it’s not core to their business, and the CFO of the firm thought he was getting decent FX rates from his Canadian bank, the company had never looked into managing foreign-exchange exposures.

    Recognizing an opportunity to save the company money, its advisor points out how often currency exchange rates fluctuate and how a small change can impact profits.

    On the advisor’s suggestion, the CFO calls the company’s bank for an FX rate, and is quoted a rate of CDN$1.0560/US$1.00.

    So, to obtain US$500,000 for the company’s monthly transfer, it requires CDN$528,000. Immediately thereafter, the CFO calls an FX company and is quoted a rate of CDN$1.0500/US$1.00. The rates look close enough, but in fact, only CDN$525,000 is needed with the FX company’s rate to obtain US$500,000 – for a savings of $3,000 per wire transfer, or up to $36,000 per year.

    Like most companies in Canada, this firm’s financial results are only now starting to recover from the recession. But with the additional savings from the FX company, the firm will now be able to spend more on other activities – or hire a much-needed employee.

    Case Study:

    Using FX For Foreign Property Purchases

    With the Canadian dollar close to par, a CEO of a marketing company in Canada returned from a trip to Florida where he and his wife agreed to buy a luxurious vacation home for US$250,000. Closing was expected to take up to 60 days.

    This was a significant investment for the family, and they wanted to ensure they took advantage of the high Canadian dollar, as their purchase was in U.S. dollars. Not knowing the final purchase price in equivalent Canadian dollars, because of the fluctuating exchange rates, was a cause for concern. Moreover, the bank’s currency exchange rates were materially higher than what the family had expected.

    The family’s advisor suggested they consult with an FX specialist. Just as businesses do, private clients working with an FX company generally enjoy lower rates than the banks provide, and can use forward contracts that allow a buyer of a currency to lock in today’s FX rate until a predetermined time in the future.

    Since the FX rate at the time was close to parity, the family decided to lock in the FX rate at CDN$1.01/US$1.00 and have cost certainty on the purchase. With the wild swings in exchange rates due to sovereign debt issues in Europe and uncertainty over global growth, the family was able to sleep peacefully at night, not worrying about currency fluctuations.

    Moreover, when the transaction on the vacation home closed two months later, the rate was CDN$1.0600/US$1.00 – meaning the family saved $12,500 and avoided having to dip further into its line of credit to fund the purchase.

  • Rahim Madhavji , is president of Knightsbridge Foreign Exchange.

    Mark Borkowski