Three-quarters of the businesses that are hedging the dollar via Scotia McLeod’s Prairie Futures Group are farmers, and more are rapidly coming on board. Protecting against currency swings is hot for farmers at BMO Capital Markets too, and at other institutions as well.
The volatile American dollar isn’t the only reason, although it is a key driver. Also important is that farmers can finally buy currency insurance in increments of under $100,000, and that they’re more savvy.
Of course, the one thing that hasn’t changed is the dependence of many Canadian farmers on U.S. markets, either because they’re producing commodities where prices are based off the big boards in cities such as Chicago and Minneapolis, or because farmers north of the border are directly selling to buyers south of it.
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The roller-coaster ride that is otherwise known as currency exchange is exposing all those farmers to more risk than ever.
“Managing that risk makes a lot of sense for our clients,” says Ron Rylott, director of business development for foreign exchange Products at BMO Capital Markets in Toronto.
Scotia McLeod’s Grant Hinrichsen sees another driver too. It’s the farmers. “It’s a product of greater volatility in the market and farmers becoming more knowledgeable of their marketing options,” says Hinrichsen, commodity futures specialist based at Winnipeg.
“There’s a lot more flexibility using futures and combining futures with your other cash transactions with line companies and grain companies,” Hinrichsen says. “It’s a very important tool to have in your tool box when you’re marketing grain to at least have the option of using futures contracts for your marketing purposes.”
Currency hedging is one of those tools, and farmers who want to look into it need can start with their bank, fund, or licensed commodity broker.
“A hedge is a transaction where you’re offsetting risk,” explains Hinrichsen. “The whole point of the transaction is that it’s removing risk and giving you more certainty regarding your bottom line.”
Futures transactions are among the three options available to farmers.
Futures contracts…
Futures contracts tend to be traded in lots — usually of $100,000 or more — and Canadian dollar futures trade in March, June, September, and December months. Putting on a futures contract means the buyer has to put down an initial deposit — which comes out of your account — with the futures exchange. When the position is closed out, the money goes back into the account, plus or minus any moves in the value of the futures position.
On a $100,000 contract, Hinrichsen explains, “Every one point move in the futures contract is worth plus or minus $10 and is deposited or withdrawn from your trading account, and that adjustment is done every day.”
The risk is market exposure, Henrichsen says: “Every point move is a $10 move in your trading account. So if it moves five cents, that’s a $5,000 move…”
Large downward moves could lead to margin calls, where farmers would have to put up additional funds to maintain their market positions.
An increasingly popular option is forward contracting over the counter or through a bank. Forward contracts are based on interest rate differentials between the two currencies hedged.
Outlooks do change. “Interest rates in Canada are actually higher today than they are in the U.S. and the implication is rates will continue to go higher in Canada, where that’s not the case in the U.S.,” Rylott said when interviewed in October. “And the result of that in the forward market is that future U.S. dollars are valued higher than they are today, so that’s the good news for our exporters.”
Or forward contracts…
With a forward contract, you’re guaranteed an exchange rate on the amount that you’ve hedged, but you don’t participate in a favourable market movement.
“So if you were 100 per cent hedged at $1.03 today and the market moves to $1.04, then there’s an opportunity cost that you’ve missed,” Rylott says. On the other hand, Rylott continues, “If the market moves against you, obviously you’re totally protected.”
Other differences between futures and forward contracting include that with the latter, there aren’t any brokerage fees, and the contract is settled on a specific day of the month rather than any good business day.
Also, futures contracts tend to be traded in lots — usually of $100,000 or more, which is not only too large a lump for many farm marketing applications, it can also be downright scary. The more gun-shy may therefore prefer forward contracts, which through an online offering through BMO, can come in amounts as small as $25,000
Errol Anderson of Pro-Market Communications in Calgary says many feedlots use the $100,000 contracts but he agreeds many farmers would find the smaller amount attractive.
“Mind you, $100,000 these days is not that big a deal,” Anderson says.
Or the third alternative
The third alternative is to buy a currency option, which functions similar to options in the grains market. A currency option gives you the right to sell or buy a specified number of dollars at a set price at a certain time in the future, but doesn’t oblige you to do so.
“If you’ve got a 98-cent call and the futures contract expires at 99, you’ll get assigned a long futures position at 98 cents and if the futures are trading at 99 it would automatically be worth $1,000,” says Hinrichsen. “Otherwise, if it closes below your strike price, your option would expire worthless. But of course you had the advantage of having your hedge on against a rising Canadian dollar.”
There’s less risk using call options in as much as the risk is known up front and is quantified in a specific number, i. e. the premium, or the cost of the right to buy an option.
“Say it costs $700. If your option expires worthless, you’ve lost the $700 and that’s your opportunity cost of having the hedge on. If the option expires ‘in the money,’ you’ll have (a profit),” Hinrichsen says.
More sophisticated strategies can reduce even that level of risk. Options fees can in fact be reduced to zero by trading both sides of the option, that is, buying both a call (the right to buy) and a put (the right to sell), says Rylott. This strategy also provides a floor and a ceiling on the currency, he adds. “You’d never sell your U.S. dollars at less than ‘X,’ but never greater than ‘Y.’”
To be fair, there is also a fourth alternative. That’s the alternative of doing nothing at all. But that “hoping rather than hedging” strategy comes with its own risk, says Rylott. If the market moves against you, you’re unprotected.
Going for average
A big part of what BMO does when speaking to clients is to help to determine the appropriate amount for them to hedge, Rylott says.
“A very common strategy would be a middle-of-the-road hedge where you’ve taken 50 per cent of your exposure and you’ve hedged it so you’ve brought certainty to half your exposure,” Rylott says. “The reason why clients tend to like that strategy is regardless of which way the market moves, they’re getting averaging over their entire exposure.”
But for some ag sectors, that isn’t enough. Produce and cattle industries tend to be 100 per cent hedged, for example, since they have very little wiggle room if the currency moves against them.
Overall, however, farmers seem to be leaning toward forward contracts, partly because they’re familiar with similar risk management tools.
Rylott says farmers have proven effective currency hedgers. “In my experience, farmers are better at this than many of our commercial clients,” he says. “Part of the reason for that is their experience in hedging commodities like wheat, cattle, soybeans, or what have you. They understand hedging and the risks associated with it and managing currency risk to them is not unlike managing their commodity risk.”CG
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“In my experience, farmers are better at this than many of our commercial clients,” says BMO’s Ron Rylott. “They understand hedging and the risks associated with it.”
