A New Framework for Foreign Exchange Risk Management in the Canadian Department of National Defence

Abstract

There has been little research on the applicability and utility of private sector financial risk management practices within public or non-profit institutions and in particular the Canadian Department of National Defence. We examine the historical magnitude of the DND's USD foreign exchange exposure (averaging 7.1% per annum over the study period April 1990 to October 2002) and compare the current no hedge approach to a passive and active financial hedging strategy. The results of our study suggest that an active hedging strategy employing one-year plain vanilla forward contracts consistently outperforms the DND's current no hedge approach and reduces the impact of adverse currency fluctuations in the order of 2.2% per month. Furthermore, the use of forward currency contracts lessens the impact of exchange rate fluctuations experienced between the time of budget allocation and expenditure and offers a greater degree of stability in the planning, budgeting and liquidating of foreign currency obligations. Foreign currency hedging affords an opportunity to limit the DND's foreign exchange risk and achieve a significant level of savings on its annual foreign currency expenditures. This approach could be of benefit to other Canadian Government departments and potentially other nations with similar forms of foreign currency exposure.