The four Ps of hedging currency risk

Ryan Booysen, MD at DG Capital Forex

Currency fluctuations are a key business risk for importers and exporters, no matter their size.

Small and medium-sized enterprises (SMEs) may believe that managing forex risk is only for big multinational corporations. Global research1 has found that while 77% of SMEs trading internationally had a formal written forex risk-management policy, only half were monitoring their exposure at least weekly. The survey found that among SMEs and mid-caps the greatest hindrance to managing their forex risk was a lack of knowledge and in-house skills for them to deal with the complexity of currency risk management.

At DG Capital Forex, we review the four Ps of hedging currency risk, the elements that influence how and when to hedge your forex risk to help simplify the process. Using these, we are able to assess the risk you are facing and craft suitable strategies to manage that risk.

1. Pricing decisions

When exporting, you may need to price your goods or services in the currency of the country with which you are trading. If the exchange rate moves against you, i.e. it strengthens, you will receive fewer rand per unit of the foreign currency which could destroy your profit margin. The opposite would apply in the case of an importer. A falling rand would mean tightening margins and pricing pressures for importers.

Whether you are an importer or an exporter, there are several pricing decisions that you need to make which will have a significant impact on your business. Firstly, you need to decide whether to price your goods or services in rand or in a foreign currency and secondly, you need to decide on the actual price you will charge. Both decisions entail risks.

If the rand is fluctuating within a R1.00 band, the pricing risk can be high so reaching those decisions needs to be based on accurately calculated data. You cannot guess or thumb suck a forecast and then add on a margin. At some stage, you need to provide a quote to clients and at this point you need to peg a rate and set a price. It is here where your forex risk begins and when you need to start your risk management process. Using a formal pricing model together with risk management strategies ensures that your pricing will be based on the most accurate rate to your client and you would be in a better position to ensure profitability.

2. Products

When setting your price, you also need to take into account the product that you are using and cost it accordingly.

A Forward Exchange Contract (FEC) is a contract to buy or sell a stipulated amount of currency using the prevailing spot rate at the time, for settlement at a future date. It will thus protect you from currency fluctuations, but comes at a cost. If, for example, you are using a 6-month FEC, it will cost you about 40 to 42 cents. If you had priced that at only 30 cents above the market rate, you would be in the red for the transaction.

Other products to consider would be currency futures (which are similar to FECs but are exchange traded as opposed to OTC) and currency options (which can be understood as rate insurance – you pay a premium to guarantee a rate). Options also allow for flexible structures like collars which can be cheaper because an additional option is sold to fund the “protection” option, however participation in a favourable movement is limited.

A business’s cash-flow, risk appetite and hedging policy will also play a roll in deciding which products can be used.

3. Payment terms

Depending on the payment terms that you allow your customers as an exporter, your company can be exposed to currency movements while you wait for settlement. This could add to the risk that you face and your profit margin if the rate moves against you. If your client has, say, three months to pay you, this could add to the price of the hedging product and provision needs to be made for this.

If you have terms with your clients, it is better to reduce some of the risk as opposed to leaving the entire exposure open. By strategically hedging a portion of the expected payment when the transaction is confirmed, you can reduce your sensitivity to adverse market movements.

4. Prevailing Market conditions

The most suitable product to hedge your risk will depend on the prevailing market conditions. Generally, there are themes that dictate the market trend at any given moment. It could vary from geo-political risk (such as Russia’s invasion of Ukraine) to the prevailing market expectation of the interest rate cycle (are we in a hiking or cutting cycle) as well as the local political environment (such as the 2017 ANC elective conference and the run up to it). These themes create trends which can vary from an uptrend to a sideways trend to a downtrend to a blowout.

The actions to take in blowout situations would clearly vary for different businesses. For importers, we would advise using call options. However, for exporters, the rate is advantageous, so we would advise fixing it using collars or geared collars, depending on one’s risk appetite.

When the rand was trading at R19.40/$ during the months leading up to lockdown and the downgrades, our advice to importing clients was to buy options rather than FECs if they needed to hedge their forex exposure. An FEC locks you into that rate with no chance of participation if the rate were to move back in your favour.

A recent example of a blowout came in October/November 2021 when the currency lost 12.5% within a few weeks slipping from R14.49 to R16.31. A perfect storm hit the rand as the 1 November 2021 elections saw numerous hung municipalities, the South Africa authorities announced the identification of the Omicron variant of Covid-19 in the country and turmoil for the Turkish lira affected the rand which trades as a proxy for the lira in highly volatile periods.

But any importers who locked in the rand at its weakest level around R16.31, would not be happy to see it trading more than 10% stronger at around R14.65 currently, so you definitely need to match the product to the circumstances.

Putting it all together

While it looks expensive to meet the collateral requirements and possible costs of hedging because it puts pressure on working capital, especially for an SME. Businesses with offshore exposure should, counterintuitively, be looking at the more expensive hedging tools that protect against any further downside potential but would offer participation in the event that you see a recovery.

When the rand is in your favour, then it would be appropriate to take the cheaper hedging option. This rule of thumb applies equally to importers and exporters

There are cost-effective methods of protecting your business against the risks that you face as an importer or an exporter. It is better to utilise accurate pricing and pro-active risk management strategies than to leave it to chance. If in doubt, rather speak to market experts than put your business at risk.