A common misconception about Canadian companies that export goods to the U.S. is that they are immune to currency risk, as most use hedging strategies to protect the revenue they obtain south of the border. However, during these turbulent times, these companies are adopting more flexible strategies, leaving their Canadian investors more exposed to currency fluctuations.

As result of this change in strategy, you need to pay closer attention to these companies’ income statements and the bigger swings in their quarterly numbers — differentiating between paper losses and real losses before passing judgment on their performance. You also need to make your clients who are invested in such companies aware of these challenges.

In particular, Canadian exporters — especially those in the natural resources and manufacturing sectors — are finding themselves backed into a corner because the Canadian dollar is showing little to no signs of backsliding against the U.S. dollar. This uncomfortable position arises for two reasons: a high C$ means that these companies’ goods are more expensive south of the border vs goods from other foreign jurisdictions; and it’s also impossible for these companies to lower the prices on their products any further. In fact, lowering prices would reduce their profit margins while, given the quasi-economic recovery, not necessarily boosting sales volume enough to compensate.

As a result, the rising loonie continues to plague the bottom lines of these companies. For example, Calgary-based Suncor Energy Inc. lost $472 million from foreign-exchange adjustments in the quarter ended Sept. 30, up from the $248 million it lost from FX adjustments in the same period a year prior. And although Suncor uses derivatives hedging to try to offset those losses, the gains from this tool in the recent quarter were only $14 million.

Similarly, Toronto-based Maple Leaf Foods Inc. lost $6.7 million because of changes in its FX adjustments and unrealized derivative losses in the nine months ended Sept. 30 — a stark contrast to the $6.3 million it gained on those items, overall, in the same period in 2009.

In theory, with the right currency hedging strategy, a company should be able to buy itself time to make structural adjustments to its business and lower its costs on the operations side in order to adapt to the higher C$.

However, in practice, doing so remains a challenge for many Canadian exporters — and the currency hedges they employ often don’t buy them the amount of time they need, says Murray Thomas, head of FX consulting for corporations with Toronto-based OANDA (Canada) Corp. ULC: “Many Canadian companies are still rethinking their long-term hedging strategies and learning to become efficient, cost-wise, to combat the higher prices.”

Before the recent recession, a Canadian natural resources exporter may have had a fixed hedging policy in place for two to five years out; however, the time period for trying to secure prices is a lot shorter now, says C.J. Gavsie, managing director, corporate and institutional foreign exchange sales, with Toronto-based BMO Capital Markets Corp.: “A company that has a shorter time horizon leaves itself more flexible to current market conditions.”

The advantage of adopting shorter-term FX hedging strategies in turbulent markets gives companies that sell goods to the U.S. more control in reacting to big currency swings, which could lead to a huge slide in revenue if the loonie continues to rise, says Gavsie: “[FX] hedging in the shorter term allows you to capitalize on the higher C$ when you need to, as opposed to a fixed policy, in which you lock everything up in advance.”@page_break@For example, an exporter that is looking to hedge its revenue in the future can buy a hedging product, such as an option, and pay a premium today to protect today’s exchange rate, yet still have right to exercise the option if the C$ continues to rise.

Such a firm can also use a more active FX hedging strategy, such as buying a “zero-cost collar,” which is a pair of options that ensures a company won’t lose on the downside of the US$, but also limits the upside.

For example, an oil exporter that sells to the U.S. can buy a collar that guarantees it will be paid between $1.01 and $1.03 for every US$1 of revenue. So, if the C$ rises to parity or higher, the company would get paid $1.03; but on the flip side, if the C$ falls precipitously, the company would get paid $1.01.

However, more complicated options-based strategies don’t always work best, says Thomas, as they require more bank transactions and have a higher embedded cost: “Over a long period of time, simpler products such as forward contracts can save you money, as they have less associated transaction fees.”

The key for you is to take the time to understand how these tools fit into a company’s FX hedging policy, and how active the firm is in employing them, so that your clients aren’t opening themselves up to more volatile FX swings than they can handle.

The more active an FX hedging policy, the more likely that products such as derivatives will be used, as companies leave themselves more open to current market conditions. “Investors need to be savvy about what currency hedges companies have in place,” says Gavsie, “and not be blind to the risks a company is taking.”

You also want to be wary of the type of accounting methods a company is using. Some firms use “hedge” accounting, which takes into account the use of forward contracts and smooths out currency swings, while others don’t, making their numbers a lot more volatile from quarter to quarter. Thus, it’s important to take the time to understand how these FX hedging strategies translate on paper.

It’s also important to view a company’s FX hedging strategy in the context of its competition. For example, if oil is selling at US$90 a barrel and a firm such as Suncor locks up its inventory with a forward contract that sells oil at US$100 a barrel, it doesn’t really have an advantage over its competitors if those competitors also are locking in at US$100 a barrel, says Thomas: “Hedging isn’t just about what one company is doing; it’s about what everyone is doing.”

Although employing FX hedging tools such as options and collars occurs at a financial level, there are also structural changes a company can make to combat the high C$, says Bob Gorman, vice president and chief portfolio strategist with TD Waterhouse Canada Inc. For example, a manufacturer can start outsourcing some of its production from Canada to a lower-cost jurisdiction such as China. “Outsourcing some of those parts,” he says, “allows a manufacturer to produce its goods at a lower cost.”

Companies that have a better handle on currency risk tend to be those that build natural FX hedges into their business model. For example, oil and gas company Encana Corp. matches its revenue in US$ and its financing for those operations in US$. By financing its inventory in the same currency in which the firm sells its products, Encana has, in effect, cancelled out currency risk, says Thomas: “By financing its operations in the same currency in which it sells its products, it eliminates exchange risk on the cost of debt, so if the revenue is lower due to a stronger C$, it’s not like the cost of the financing is going up at the same time.”

Although some market observers argue that currency fluctuations balance out over the long run and, thus, are irrelevant if clients are invested in a company for the long haul, Gorman argues otherwise: “As we have seen in the past little while, it can have a big impact on your results in the short term.” IE