If you own a business that is exposed to the risk of currency fluctuations, you could implement one of two classic hedging strategies which would serve to mitigate currency exposure emanating from importing or exporting goods abroad which invariably protects the profits generated from the operations of the business.
But first, what is hedging and why is it a strategy you should consider? “Hedging is all about mitigating against currency risk and the financial losses it could trigger,” says Citadel Global director Bianca Botes, a respected expert on foreign exchange and treasury-related matters, including currency fluctuations, exchange control and currency risk.
“Hedging is a risk management strategy employed to offset losses in investments by taking an opposite position in a related asset – ultimately protecting your forex against the inevitable unpredictability of currency fluctuations, but which may come at the cost of reducing your profits.”
Any business that imports, exports, or has foreign subsidiaries faces the threat of currency risk and could benefit from hedging as it ultimately affects profits.
The recent strengthening of the rand against the United States (US) dollar is a case in point. South African businesses exporting goods to the US would have been paid less in rand terms, negatively impacting profits. Conversely, South African businesses importing goods from the US would have benefited from paying less for the goods in dollar terms. The inverse would happen if the rand were to suddenly weaken against the dollar.
TWO CLASSIC HEDGING STRATEGIES TO PROTECT YOU EITHER WAY
“The best way to deal with currency risk is to put a strategy and policy in place to hedge your risk, reduce the impact of currency fluctuations on business profitability and to manage your forex more effectively,” says Botes.
Businesses with forex exposure can benefit from two classic hedging strategies which utilise derivatives, granted they have firm and ascertainable commitments in place, such as invoices.
STRATEGY 1: OPTIONS
Currency options resemble an insurance policy that serves to protect your business against currency volatility. There are various types of options available, and the type used will depend on the nature of your business, your risk appetite, and your business payment cycle.
Here is an example: To avoid losses, importers purchasing goods in a foreign currency may use “call options”, which provide the option to buy a currency at a set price, or exporters may use “put options” whereby exporters selling goods in exchange for a foreign currency have the option to sell a currency at a set price.
STRATEGY 2: FORWARD CONTRACTS
Forward cover provides businesses with greater certainty on future foreign currency payment obligations by fixing the exchange rate for a payment at a future date. The forward rate is determined using forward points. These are calculated using the difference between the two interest rates of the countries in question and multiplying this by the number of days that the forward cover is booked for.
Here is an example: A South African company wishing to purchase US dollars enters into a forward exchange contract for 76 days. The spot rate is R16.50/$, the US interest rate is 0.25%, and South Africa’s interest rate is 3.75%. The difference in interest rates is therefore 3.75% – 0.25% = 3.5%. Using the 360-day convention, one would multiply the difference in interest rates by 76 days: 3.5% x (76/360) = R0.12* (*rounded for simplicity), then add the forward points to the spot rate to determine the forward rate: R16.50 + R0.12 = R16.62.
WHICH KIND OF HEDGING STRATEGY IS RIGHT FOR MY BUSINESS?
The type of hedging that is most suitable for a particular business depends on factors such as whether the business is buying or selling currency, what the market conditions are, what the business manager’s risk appetite is, and the length of time before a derivative contract expires referred to as the tenor.
Businesses need to consider the risks that currency fluctuations, such as the weakening of the rand, could have on their bottom line and then weigh up the cost of the hedge, with the potential of a negative currency move. An expert forex and treasury advisor would be able to recommend which option would be best for the business while considering the nature of the industry as well as the global marketplace at the time.