Summary of the Survey on Canadian Corporate Foreign Exchange Hedging

Each year since 2004, the Bank of Canada has undertaken a questionnaire with banks that are active in the Canadian dollar foreign exchange market through offices in Toronto and/or Montréal. These questionnaires focused on the foreign exchange hedging 1 activities of their corporate customers. The purpose of these questionnaires has been to gain a better understanding of the degree to which hedging activities are evolving in corporate Canada, whether through reliance on natural hedges or through the use of financial market instruments, and to see the extent to which banks' corporate client base rely on such strategies to buffer the effects of changes in the level of the Canadian dollar. The latest survey was sent to eleven banks in late May of 2007, and the Bank followed up with individual meetings in June 2007 with the respondents. 2

The evidence collected from this survey was anecdotal and reflected the banks' evaluations of their clients' hedging activities and the effects of the stronger Canadian currency. Responses to the questionnaire varied significantly because of the differences in the client bases of the banks and variations in the nature of the hedging activities transacted as well as the subjective nature of the questionnaire. Nonetheless, common themes emerged, as highlighted below.

Results

(1) Banks reported increases in the percentages of Canadian companies that they considered to be either experiencing a very negative or a very positive direct effect from the appreciation of the Canadian dollar. 3

The results of the 2007 survey compared to previous years' showed that a higher proportion of the respondent banks' clients appeared to be negatively affected by the Canadian dollar's strength. The percentage of firms expected to be very negatively impacted by the stronger Canadian dollar moved from around one-quarter to just under one-third, according to those surveyed, while the percentage expected to be just negatively affected held steady.

There was also a slight increase in the percentage of Canadian companies that the banks considered to be experiencing a very positive direct benefit from the stronger Canadian dollar. The banks suggested that this group included such firms as importers with U.S. dollars to buy and commodity producers whose underlying products' price gains more than offset any currency effects.

The proportion of client firms for which the Canadian dollar's appreciation was seen as either neutral or moderately positive declined.

Many banks noted that they have been impressed by the resilience shown by the Canadian economy as a whole over the course of the last five years in the wake of the large appreciation of the currency since 2002.

(2) Banks reported that many firms continued to be shielded from the stronger Canadian dollar to differing degrees by a combination of natural and financial hedges.

The most important factor cited by respondents behind this apparent resilience to the appreciation of the Canadian dollar was the natural hedge afforded by rising commodity prices. The importance of commodity prices as a natural hedge had been cited repeatedly by respondents in all previous surveys.

Other hedges most cited by respondents included:

1. the residual protection afforded by existing financial hedges, although these hedges are being rolled at less advantageous currency levels and thereby only buy time for companies to adapt by delaying the impact of the appreciation;
2. the use of U.S.-dollar-denominated borrowing;
3. shifting to lower-cost offshore production, as well as mergers and acquisitions of foreign capacity, although such strategic moves are usually predicated on longer-term views about the currency's likely equilibrium level and the compatibility of such diversification with a firm's existing business model; and
4. the movement to U.S.-dollar-based accounting, although there has been little if any new use of this option over the past two years as most firms who wish to make the transition have likely already done so.

(3) Banks reported that the degree of financial hedge coverage and the average term of hedges targeted by U.S.-dollar sellers had continued to decline.

Almost all survey respondents reported that, on balance, the degree of coverage of financial hedges, as well as the term of the hedges for U.S. dollar selling firms had continued to shrink in comparison to what had been typical in the past. This was often associated with exporting firms that were experiencing negative currency effects from the stronger Canadian dollar, but that were unwilling to lock-in the exchange rate at current levels. Such firms preferred instead to use swaps or even to hold on to their US dollars once delivered, and just covered funding needs through the spot market in the meantime.

Several factors were cited in the 2007 survey to explain the declining use of financial hedges:

1. a belief as of June 2007 that the Canadian dollar would weaken somewhat at some point during the second half of 2007;
2. an unwillingness by some firms to lock in a level for the Canadian dollar that was significantly stronger than their 2007 budgeted levels; 4 and
3. the fact that forward contracts traded at a discount (in terms of Canadian dollars per U.S. dollar), which would lock in an even stronger Canadian dollar level than would the then current spot levels.

In comparison, the banks reported that some importers were looking to further increase the average term and coverage ratio of their U.S.-dollar-buying hedges and to lock in what they saw as reasonable long-term levels for the Canadian dollar, while a minority were reluctant to lock-in hedges as long as they expected the exchange rate to continue to move in their favour. Note that U.S.-dollar buyers typically represented only about 5 per cent to 20 per cent of the corporate client base of the banks surveyed.

(4) While the majority of firms that hedge using options were reported to still prefer simple structures, a gradual increase in the use of more exotic structures as well as some new corporate users of options as hedges were reported.

According to respondents, simple option structures continued to be favoured due to accounting conventions that discourage the use of more complex option structures since such strategies are less likely to gain favorable hedge accounting treatment.

However, several new trends in options use began to emerge in 2007:

1. More firms were choosing to undertake more complex option strategies which better addressed their economic exposures; these firms appeared to be prepared to live with the concurrent increase in mark-to-market balance sheet volatility;
2. More use of participatory option structures which also act as protection for Canadian dollar buyers against extreme currency moves. Conversely, Canadian dollar sellers sought structures which allowed them to reduce the opportunity cost of fully hedging their exposures should the Canadian dollar continue to appreciate; and
3. For the first time since the survey has been conducted, there were reports of a noticeable interest by commodity producers (excluding the oil & gas sector) in option strategies to address their currency exposures. The outperformance of the currency over certain periods was credited with sparking this interest. However, a lack of time and qualified resources, lingering beliefs that shareholders of certain commodity companies wanted foreign exchange exposure when investing in those firms, and the widely held view of oil & gas producers that the natural hedge provided by their underlying commodity was sufficient, were among the reasons cited that continued to keep many such Canadian firms from addressing their currency exposures.

For further information, contact:

Wally Speckert
Assistant Director, Research
Financial Markets department
613 782-8102