Many companies in South Africa have foreign exchange exposure. Making or receiving payments in foreign currencies inevitably results in foreign exchange risk. These risks are generally well understood but the opportunities and methods to realise these opportunities are not.
There are many different approaches and methods used to with foreign exchange risks. Many companies, particularly smaller businesses, choose to book spot trades, although the risk could have already crystallised days, weeks or even months before the trade was executed. By trading spot, you execute the trade at the prevailing market exchange rate. This approach does not allow the company to form a view on exchange rates, which negates the possibility to trading at a more favourable level. The decision to trade spot is a choice or a forced decision based on various factors including lack of access to forward exchange facilities, lack of exposure or understanding of forward exchange contracts and/or cash flow constraints.
Other companies, especially large corporates, have strict risk management policies that require them to cover foreign exchange exposures with forwards, regardless of the prevailing rates. This type of policy will eliminate risk but could result in these companies being locked into unfavourable exchange rates with minimal room to implement corrective action.
Merchant West Capital markets assist various companies by making use of forwards, spots, orders and derivatives as hedging techniques in order to limit risk, while attempting to maximize upside potential. One such example is the stop loss, which involves setting an order to execute the trade at a predetermined level. Should the market move against you, the order will be executed at the predetermined level, but if the market moves in your favour the trade can be executed at a more favourable rate, which could result in trading profits for the company. The use of a stop loss involves some risk, as the trade could be executed at a level worse than the available market rate of exchange. Importantly however, the level of risk is quantified and predetermined upfront, while still allowing upside potential through favourable movements in the rate.
This strategy and any strategy for that matter comes with associated risks. Markets continuously fluctuate and the maximum risk a company may be willing to take dictates how far the stop loss can be placed from the prevailing spot rate. In order for strategy to have the best chance of success, the stop loss cannot be set to tight.
This is exactly where the Merchant West Capital Markets risk sharing option adds value. We are willing to share in this risk with our clients, allowing more risk to be taken in the position while reducing the net financial risk to you. Practically the process works as follows, we agree a current market price as a benchmark, execute a stop loss at the agreed level and quantify the amount of total financial risk in the trade. We share the financial risk (or reward), on a 50/50 basis, this ensures that we have skin in the game and are aligned with our clients. Normally, a predetermined time frame is set, after which any profit or loss is shared between Merchant West Capital Markets and the client.
The position is also actively managed by moving the stop-loss level down should the market move favourably, essentially shifting the focus from protecting losses to protecting profits. This risk sharing option is great for companies who are looking to capitalise on favourable market movements while ensuring their risks are effectively managed. Speak to one of our Capital Markets professionals to find out more, you can email us at MorganY@merchantwest.co.za