Summary of the Survey on Canadian Corporate Foreign Exchange Hedging

Each year since 2004, the Bank of Canada has surveyed banks that are active in the Canadian-dollar foreign exchange market. Survey questions focus on the foreign exchange hedging activities of their Canadian corporate customers in order to better understand the degree and manner 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 gauge the extent to which the banks' corporate client base relies on such strategies to manage the effects of changes in the level of the Canadian dollar 1. The latest survey was sent to 15 financial institutions in June 2008, including several new participants located in New York. The Bank followed up with individual meetings with the respondents in July 2008. 2

The relatively wide variation in the banks' responses regarding their clients' hedging activities and the effects of the stronger Canadian currency, reflects differences in the various banks' client bases, both regionally and sectorally. It may also reflect the anecdotal nature of the survey, as well as the focus of each bank's respective corporate contacts. Nonetheless, common themes emerged, as highlighted below. 3

Results

(1) In June 2008, Banks reported that, on average, the percentage of Canadian companies considered to be experiencing a very negative direct effect from recent movements in the Canadian dollar should be lower in 2008 than in 2007. 4

The results of the survey conducted in June 2008 concerning the impact on Canadian companies of the strong Canadian dollar in 2007 closely mirrored the expectations that participants had indicated in the 2007 survey. Although compared with previous years, a higher proportion of the respondent banks' clients were considered to have been very negatively affected by the Canadian dollar's strength in 2007.

However, when respondents were asked to comment on their expectations for their clients in 2008, the percentage of firms expected to be very negatively affected by the stronger Canadian dollar moved back to around 25 per cent, the typical survey response until last year. This more positive outlook appears to reflect a combination of the ability of firms to adapt to the stronger currency and expectations that, at least for the time being, further appreciation of the Canadian dollar was unlikely.

This sentiment was also reflected in the slight decrease in the percentage of Canadian companies with U.S. dollars to buy that are expected to experience a very positive direct benefit from the stronger Canadian dollar in 2008. Although respondents' views on the future direction of commodity prices were mixed, those that expected a decline in commodity prices also dampened the extent of their positive expectations for the impact of Canadian dollar appreciation on commodity producers. Over the past few years, rising product prices had more than offset any negative currency effects experienced by those producers.

Again this year, many banks noted that they have been impressed by the resilience of the Canadian economy as a whole during the large nominal appreciation of the currency since 2002.

(2) In June/July 2008, Banks reported that a combination of natural and financial hedges continued to shield many firms from the stronger Canadian dollar to differing degrees.

Respondents cited the natural hedge afforded by rising commodity prices (as of the time of the survey) as the foremost factor behind this apparent resilience to the appreciation of the Canadian dollar for commodity producers. The importance of commodity prices as a natural hedge has been cited by respondents in all previous surveys.

Other factors frequently cited by respondents in June/July of this year included:

1. the residual protection afforded by existing financial hedges which delay the impact of the Canadian dollar appreciation. Maturing currency hedges are being currently rolled at less-advantageous levels;
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 both these factors were cited less often than in previous years.

(3) Banks reported that the degree of financial hedge coverage and the average term of hedges targeted by U.S.-dollar sellers have continued to be quite low compared with historical levels.

Almost all respondents reported that, on balance for firms selling U.S. dollars, the degree of coverage from financial hedges, as well as the term of the hedges, had continued to shrink in comparison to what had been typical in the past. This was often associated with export-oriented firms that were experiencing negative currency effects from the stronger Canadian dollar but that were unwilling to lock in the exchange rate at the prevailing levels at the time of the survey. Such firms preferred to use foreign exchange swaps or to hold on to their U.S. dollars receipts, meanwhile covering their current funding needs through the spot market.

As of July 2008, a belief that the Canadian dollar had only limited room for further appreciation, at least in the near term, and would likely weaken somewhat during the second half of 2008 was the primary factor cited in the 2008 survey to explain the current lack of interest shown by many accounts in using financial hedges.

In contrast, 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. Others had reduced their hedging programs, largely on the premise that the currency would remain relatively rangebound over the near term. 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) The heightened market volatility and effects of the credit market events appear to have affected the hedging behaviours of Canadian corporations.

Survey participants observed a wide range of behaviour regarding the use of options by their Canadian corporate clients. Many firms, especially larger corporations, continue to favour simple option structures. This is likely because of accounting conventions that are said to discourage the use of complex structures. There was also a preference for option structures that were easy to explain to Boards and shareholders and that could be accurately priced.

The trends that began to emerge in 2007 appeared to have been reinforced to some degree by the current market environment:

1. While the use of complex structures was generally noted to be down somewhat from the previous year, some respondents noted interest from medium-sized companies that wanted more complex zero-cost structures that were flexible enough to allow them to benefit if the currency moved in their favour. These firms appeared to be prepared to live with the concurrent increase in mark-to-market volatility in order to create structures that best addressed their business needs and net exposures.
2. While most clients were reported in June/July 2008 to believe that large currency moves are less likely than in the past five years, recent experience has led some buyers of Canadian dollars, as well as sellers, to look for participatory option structures for protection against extreme currency moves. Conversely, a few Canadian dollar selling accounts that expected the Canadian dollar to remain rangebound were reported to have taken advantage of the very high levels of volatility to sell Canadian dollar calls.
3. The interest of commodity producers (excluding the oil and gas sector) in hedging strategies to address their currency exposures, either through options or forward sales, continues to grow. Nevertheless, most participants noted that while interest has grown, few companies had actually moved to implementation.

Tightening credit conditions reportedly constrained the ability of some clients to implement desired hedging programs, in some cases limiting them to spot transactions because of reduced credit lines.