What Is a Currency Certificate?
A currency certificate, like a futures contract, grants the holder the right to convert a specific amount of one currency to another at a pre-determined exchange rate until a specific expiration date. The holder of the certificate is not obligated to conclude the transaction.
Currency certificates are primarily used by businesses that engage in international trade or have international branches. They serve as a hedge against unexpected and adverse changes in the value of a currency.
- Currency certificates are primarily purchased by companies that do business with companies based abroad.
- The certificate is an option to buy currency at a predetermined price within a set period of time.
- The certificate ensures the company against losses due to currency rate fluctuations.
Understanding Currency Certificates
Currency certificates are useful tools for hedging against foreign exchange risk.
This risk is that changes in currency rates can make it more expensive or less profitable to conduct business in another country's currency. The certificates reduce the impact of unfavorable future changes in the exchange rate for money received in one country’s currency but converted into another currency.
Example of Currency Certificate Use
For example, a U.S. retailer may have branches operating in Canada that do business in Canadian dollars. The company converts that revenue into U.S. dollars at regular intervals. But if the U.S. dollar weakens against the Canadian dollar, the company's revenue from its Canadian branches will get hit.
Assume the U.S. dollar/Canadian dollar exchange rate is 1.25, meaning that 125 Canadian dollars can be converted into $100 U.S dollars. Or, reversing that ratio, 100 Canadian dollars can be exchanged for $80 U.S.
If the U.S. dollar strengthens against the Canadian dollar, perhaps moving to an exchange rate of 1.35, then it would require 135 Canadian dollars to be converted into $100, and that 100 Canadian dollars would only be worth $74.
With a currency certificate guaranteeing an exchange rate of 1.25, there would be no risk of losing money if the exchange rate moves in an unfavorable direction.
Using Currency Certificates to Mitigate Risk
Companies that do business internationally regularly purchase currency certificates in order to strategically manage foreign exchange risk. The company described above could forecast its Canadian sales on a monthly basis and then purchase a one-month currency certificate for that amount.
If in any given month that the U.S. dollar weakens against the Canadian dollar, the certificate would be redeemed at the note's specified exchange rate to protect the company’s revenue for that month. If the exchange rate remains the same or moves in the opposite direction, the certificate would not be redeemed.
Currency certificates have their uses for any company that does business in a foreign currency. A company may know it owes a payment of one million Canadian dollars in 90 days. If the company purchases a currency certificate guaranteeing that amount, it protects itself from paying more than it expected because the foreign exchange rate moved in an unfavorable direction.