Commentary: FX hedging is vital to managing risk in 2014
February 26, 2014
By: Mark Frey and Scott Smith
Although we have only just ventured into 2014, already it’s clear the financial market landscape is set to deviate tremendously from the conditions we became accustomed to last year.
The flow of asset purchases from global central bankers continues to dictate the movement of asset prices, but a more robust recovery in markets like the U.S. and U.K. is altering the global economic environment, which has negative ramifications for regions whose economies are struggling to gain momentum.
As the global marketplace contends with excess liquidity draining from the system, new risk factors spread out on an international scale have presented fresh challenges for corporations participating in the commodity and FX (foreign exchange) markets, Canada’s mining sector being no exception to these risks.
The U.S. Federal Reserve is well on the path of winding down its Quantitative Easing program, and inflation remains well corralled around the globe. As such, many analysts are predicting a tough trading environment for precious metals.
For Canadian-headquartered companies that are producing commodities that are sold and denominated in U.S. dollars, the last year has been an excellent one for bringing in American dollars. The approximate 10% decline in the value of the loonie over the course of the last year has allowed corporations with U.S. dollar receivables to enjoy a welcome bump in purchasing power when repatriating those funds to Canada, helping to offset some of the decline in commodity markets.
The gradual normalization of interest rates on the long-end of the curve in the U.S. combined with a dovish Bank of Canada bodes well for companies naturally long the U.S. dollar and the trend of a rising U.S.-Canadian dollar exchange rate will likely continue for a good portion of 2014.
Although there may be further pain to come in the short-term for the loonie, the latter part of the year should see the Canuck buck gain back some of these losses, as the recovery in the U.S. gains traction and the spill-over effects of greater export demand from Canada’s largest trading partner helps boost economic performance north of the 49th parallel.
Therefore, should economic policy follow through in North America as planned, it will be a bumpy road ahead for the U.S.-Canadian dollar exchange rate.
As a result, we’re seeing mining corporations begin to use more non-traditional option-based hedging strategies to manage their foreign exchange risk, aiming at locking in some of the recent gains from the appreciation of the U.S. dollar, while still leaving room to participate in its further advances.
Option-based hedging strategies that are used in conjunction with traditional vanilla forward contracts and spot purchases create a diversifying effect that helps smooth the overall volatility witnessed from transacting exclusively in the cash or forward market, while also providing greater flexibility in terms of cash management.
Those companies operating further abroad to emerging markets are observing hurdles that are not as simple to navigate. The Federal Reserve has raised its foot off the stimulus pedal since starting its tapering campaign, and this has caused massive turmoil in emerging markets. Countries that are running large current account deficits with dwindling foreign exchange reserves have been hit particularly hard.
While this might be a blessing for companies that pay operating expenses in the domestic currency of the region in which they’re active, if a company is faced with using the U.S. dollar as an operating currency because of liquidity issues in the local market, they’ll be facing a rising U.S.-Canadian dollar exchange rate which has increased operating costs by 10% over the last year.
Adding further pressure, the impact of volatility experienced in these markets has created a far more serious issue. Countries such as Turkey for example, have been forced to hike interest rates dramatically in an effort to halt the depreciation of their currency and stem the outflow of capital. The sharp increase in borrowing costs has the potential to cut into the growth potential for these regions.
If rising interest rates choke off economic development for these areas, the likely outcome will be a reduced supply of labour and capital at the local level, generating additional enterprise risks beyond negative currency issues adversely impacting costs of goods sold.
Foreign exchange risk has often been looked at as a by-product of dealing in commodity markets, and thus not a material enough risk to be hedged, but the decentralization of risk factors and increasing volatility in FX markets are leading more companies to engage in robust risk management strategies.
The commodity market outlook isn’t particularly bright; Chinese demand is falling and central banks are looking for ways to end their non-traditional monetary policy campaigns.
A proactively managed FX hedging strategy can ease any pressure by acting as a competitive advantage, especially in using tools to smooth overall volatility and protect against sharp currency fluctuations. Treasurers and financial executives of multinational mining companies should consider that a vanilla approach to FX risk management will likely be outperformed by a dynamic strategy that proactively takes advantage of market opportunities.
— Mark Frey is senior vice-president & chief market strategist at Cambridge Mercantile Group in Victoria, B.C. He leads the firm’s growth strategy and risk solutions product development, drawing on more than a decade of experience working with corporates and banks to design and implement foreign exchange risk hedging strategies and payment solutions.
Scott Smith, CFA, is a senior market analyst at Cambridge’s Calgary office, and specializes in identifying and evaluating hedging strategies to assist corporate clients in effectively managing inherent risk to their business model, while providing market knowledge to manage these risks.
Founded in 1992, Cambridge Mercantile Group is a leading provider of global payments and currency risk management solutions, with more than 14,000 clients worldwide and offices located across the globe, including North America, Europe and Australia. Visit www.cambridgefx.com for more.