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Canadian Dollar: Friend or Foe?

  • By Marc Monyek
  • Published: 7/12/2016
Over the past two years, the Canadian dollar/U.S. dollar exchange rate has weakened to CAD1.4580=US$1 (CAD1=US$0.686) before “recovering” to the current level of 1.30(.77). The cause of this devaluation can largely be traced to the similarly unanticipated 70 percent decline in oil to the US$30 range and subsequent “recovery” to US$50/barrel. As a major oil producer, the Canadian current account balances have become increasingly negative, creating downward pressure on the Canadian dollar.

Unexpected impacts of a weak Canadian dollar

Because of the weak Canadian dollar, many companies on both sides of the border are experiencing volatility in their costs, revenues and net income. Companies exporting into Canada have seen significant price increases in Canadian dollar terms, while Canadian exporters have seen a benefit from their effectively reduced cost of local sourced inputs such as labor, occupancy and utilities. The currency volatility has highlighted additional risk areas where companies have not previously focused, such as the cost of commodities that are used in production but have underlying pricing traded in USD.

How should companies manage these risks?

Companies now facing heightened CAD volatility have some common questions, such as:
  • Is it too late to mitigate the risk? 
  • If we have existing hedges should we add to them at existing levels? 
  • What pricing decisions should we make?  

To respond optimally, companies need an effective risk management program. The key to success is having an ongoing program that is always assessing and managing risk, as opposed to making decisions based on one point in time. A point-in-time decision methodology forces a company to either “guess the market” or “avoid the market.” Neither choice is likely to be successful for a company trying to reduce its risk.

Answering these key questions also requires an analysis of a company’s position and the development of a financial risk management program. Currency and other financial risks are ongoing, so making decisions at one point in time is unlikely to positively affect results; in fact, it’s more likely to cause a company to “guess the market.” The leading best practice is to continuously monitor the risk and have a strategy in place for proactive risk mitigation.

For example, many companies implement the Six Step Model developed by EY, which enables companies to have effective risk management programs.

1. Business exposure identification.  In exposure identification, a company reviews all sources of currency risk. Having a clear understanding of the exposures is integral to understanding the risk and managing it.

2. Risk and impact analysis. Value at risk should be performed so that a company understands the sensitivity of its exposures and the financial risk. When the financial risk is understood, a company can identify its risk tolerances.

3. Policies, procedures and controls. Risk managers who take liberties with their responsibilities can cause their companies significant losses. Policies and risk tolerances need to be set and approved by management and the board of directors.

4. Risk systems. Given the magnitude of any risk management program and the cost of even a small error, effective systems are essential. Without an appropriate system, the potential for trade errors and missing exposures is significant.

5. Hedge strategy development. There are multiple factors that need to be considered, including, but are not limited to, time horizon, products (such as forwards, options and swaps), cost and effectiveness. As part of its hedge strategy, a company also needs to consider the actions of its competitors. If a competitor is not hedging and a company hedges, it is exposed to adverse currency movements in its hedges that will enable the competitor to pass through the savings to customers and undercut the hedged company on price.

6. Implementation plan. This involves all aspects of the first five steps, as well as selection of bank counterparties and documentation and development of the accounting and tax treatment. One of the most successful strategies in any hedge program is the development of a risk committee. The risk committee should include the treasurer, a risk management leader, the controller and representation from the business units.
 
It’s important to remember that a hedge strategy is a short-term mitigation of risk. If a company hedged all of its Canadian dollar exposures for two years, it would mitigate the risk over that period of time.  However, it will need to adjust to the change in the exchange rate to either the market rate at the end of the two years or the new hedged rate that the company achieved with new hedge contracts put in place prior to the end of the initial hedge. What the company has done through hedging is reduce risk and buy time to adjust to new market conditions.
 
Companies should also keep in mind that currencies often move in long-term cycles. The CAD/USD exchange rate was at 1.45 in the 1990s and may go to that level again. However, waiting for the cycle to correct can materially damage the financial position of a company.  

Marc Monyek is a senior manager in the global treasury services practice at EY, advising corporate treasurers and CFOs on financial management issues.

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