What Is a Currency Certificate?
A currency certificate is like a futures contract in that it grants the holder the right to convert a specific amount of one currency to another at a pre-determined exchange rate at or by specified expiration date. Although currency certificates give the holder the right to exchange funds from one currency to another, the holder is not obligated to do so.
Understanding Currency Certificates
These certificates are not issued explicitly to registered owners so that they trade easily. Currency certificates are also useful tools for hedging against foreign exchange risk. This risk is in an investment's value changing due to the changes in currency exchange rates. Companies use currency certificates for doing business in different countries. The certificates help to minimize the risk of unfavorable future changes in the exchange rate for funds held in one country’s currency which they will convert into another currency.
As an example, a U.S.-based company may have a division operating in Canada and they receive payments in Canadian dollars. The company expects to convert those funds into U.S. dollars in the future, but if the U.S. dollar weakens against the Canadian dollar, the company may lose money.
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 even if the exchange rate moves in an unfavorable direction.
Using Currency Certificates to Mitigate Risk
While currency certificates have a limited number of uses, regularly purchasing them offers a way for organizations to strategically manage foreign exchange risk. The company described above could adopt a strategy of forecasting its Canadian sales on a monthly basis and then purchase a one-month currency certificate for that amount.
If in any given month the U.S. dollar weakens against the Canadian dollar, that certificate could 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 need to be redeemed.
Currency certificates can also help when expenses are expected to be paid in another country. For example, a company may know it needs to pay an invoice of one million Canadian dollars in 90 days. If the company purchased a currency certificate guaranteeing that amount, it protects itself from paying more when the invoice is due even if the foreign exchange rate moves in an unfavorable direction.