Over the last decade there has been a significant increase in the number of South African companies participating in global trade. While most companies realise that currency volatility is an important component of their business risk, not all realise that the behaviour of the exchange rate can be monitored and managed on a continual basis to maximise returns on their trading investments.

Currency fluctuations are a global phenomenon and affect companies’ transactions directly by having an impact on their payables and receivables. This in turn directly affects their financial results through cash flow and ultimately company valuation and shareholder interest. It can be of enormous value for a company to employ appropriate currency risk management strategies to limit, or “hedge”, their exposure to foreign exchange risks.

What is Foreign Exchange Exposure?
Foreign exchange exposure measures the potential change in a company’s present value, its profitability, net cash flow and/or the market value of its net assets due to unexpected changes in currency exchange rates. For instance, when a company sells to a foreign buyer and accepts the buyer’s currency for payment, the selling company bears the risk that the foreign currency might depreciate and that it will receive a lesser value in its domestic currency once the foreign currency is converted.

Check your forex risk exposure:
Does your company:

• Export or import in foreign currencies?
• Have transactions that are affected by currency fluctuations?
• Have financial debts in a foreign country?
• Have financial assets in a foreign country?
• Contend with international competitors with different capital cost structures?

Hedging against currency volatility
More and more companies are hedging their foreign exposures as ongoing currency volatility increases the need for companies to protect themselves from foreign exchange risk. With volatile currencies playing havoc with profits and financial forecasts, the question is not if a company should hedge, but rather when and how they should hedge.

You need to consider the following factors, before deciding when and how to hedge your foreign exchange risk.

• Do you have a clear overall understanding of your own company’s foreign exchange exposure?
• What portion of your foreign exchange risk can be offset naturally? And is it in your interest to do so?
• Will shareholders benefit from hedging your exposure?
• Are there risks which it is not possible to hedge? For example, royalties or dividends?

Answering these questions will help to define the objectives of your hedging strategy. The primary objective of a currency risk management strategy is to protect the economic value of a business. Secondary to this is striking a balance between risk and return.

Too many companies do not fully understand the complexity of the underlying risks they face. They focus on isolated aspects when making hedging decisions, thereby falling short of the total business objectives. An in-depth risk profile that incorporates direct and indirect risks, shareholders expectations, corporate governance and best practice as well as possible outcomes can help overcome this problem.

Developing a Currency Risk Management Policy
The next step is to develop a risk management policy framework that quantifies the risk through a benchmarking process that specifies the benchmark rate, (either a forward exchange rate or a ruling spot rate when goods land), the hedging instruments used, and the trading disciplines employed. In addition it should define areas of accountability and responsibility with a clear separation of duties.

Many corporations do not benchmark their treasury operations and are therefore not able to quantify the value these operations add. Simply improving a portfolio against an agreed benchmark rate may not be enough if the result is, for instance, to lose market share. A more sophisticated approach involves a risk adjusted return analysis which can help a company beat the benchmark rate and gain competitive advantage, outperform the market on average, and stay in the market.

Most recently and notably, the failure by the advanced economies to understand their risk/reward profile or to manage their risk adequately has brought about the state of financial turmoil facing the world. Shakespeare knew what he was talking about: “For the want of a nail, a kingdom is lost…”

For information about using our risk management service on a free trial basis, contact IQuad Treasury Solutions.
Johannesburg Tel: 011 797 8445 Cape Town Tel: 021 657 2815