Currency Risk Management
Understanding Currency Risk: Comprehensive Management Strategies for Your Business
Background on Currency Risk
Currency Risk: According to the IMF, the South African rand is one of the most volatile currencies globally compared to advanced economies and emerging market peers. Only the Russian ruble and Argentinian peso have been more volatile in the last decade.
With this inherent volatility comes currency risk for all South African businesses dealing in international trade and different (non-rand) currencies.
With this currency risk the need for South African businesses to closely look at currency risk management strategies to protect them against such volatility.
What is Currency Risk?
Currency risk, also known as exchange rate risk, occurs when there is a change in the price of one currency in relation to another.
It is the possibility of losing money due to unfavorable moves in exchange rates.
Any company that does business in a foreign currency is vulnerable to currency rate fluctuations. Firms that operate (import or export) in overseas markets are exposed to currency risk by conducting transactions that require the payment or receipt of foreign currencies.
When a contract or purchase order is signed, it is impossible to know how much a foreign currency will be worth by the time payments are made. These currency rate variations impact a company’s accounts receivable and payable.
Examples of Currency Transaction Risks
To fully understand currency risk, let’s look at two examples: one involving a South African importer, and the other a South African exporter.
For an Importer
A South African company buys equipment in the United States for USD 200,000. On invoice day, the U.S. dollar (USD) was at ZAR 19, so the company would have paid ZAR 3,800,000 at the spot rate. However, when the payment was made three months later (due date), the USD had appreciated and was trading at ZAR 20. The actual cost of equipment was now ZAR 4,000,000, causing the company to face a foreign exchange loss of ZAR 200,000.
For an Exporter
A South African exporter makes a foreign sale worth USD 200,000. The company is billed in U.S. dollars, and payment must be made in three months. If the U.S. dollar depreciates during this period, from an exchange rate of ZAR 20 to ZAR 19, on the day the payment is received, the value of the export will be reduced by ZAR 200,000 from what the exporter originally expected. Again, the company will face a foreign exchange loss.
In both examples, the company has suffered a financial loss. However, employing a currency risk management strategy, such as forwarding, could have prevented this.
How Do Businesses Protect Against Currency Risk?
There are several strategies for alleviating exchange rate risk. Here are a few different strategies:
ZAR Billing
One straightforward way of eliminating exchange rate risk is for the contract to be specified in rand. In the case of a South African exporter, they would simply quote for the service or product in ZAR, thus ‘moving’ the exchange rate risk to the purchaser. There may be resistance to this as many companies prefer to deal in more ‘popular’ currencies such as USD, Euro, or GBP. For an importer, this may be even harder to achieve as they would need to convince the seller to change their normal/preferred currency of trading to rand.
Forward Cover
There are several types of forward cover contracts, but the basic concept remains the same. Forward cover is a simple and frequently used tool that allows you to manage currency risk by fixing your currency rate in advance. This can eliminate 100% of the risks associated with market fluctuations. For example, an exporting company expects to receive USD 200,000 in three months. Since the projected costs have been established in South African rand, if the U.S. dollar were to lose value against the rand during those three months, its profit would decrease. By using a forward contract, the company can fix the rate that will apply at the time of conversion, thereby locking in the ZAR rate of exchange.
Disclaimer - Same Day Exchange Rate
Importers sometimes use this method to avoid exchange rate risk. When the importer quotes the local price (ZAR) to their client, they add a ‘subject to’ clause. This clause states that the quoted ZAR price is ‘subject to change in line with prevailing exchange rates’ on the day the invoice is paid. This method has drawbacks: clients are not keen on committing to an unknown price when ordering, clients often see the exchange rate risk as the importer’s responsibility, it can be admin intensive, and currency rates can fluctuate significantly in hours or even instantly on market news.
When Exchange Rate Risk Occurs
When companies enter into contracts to supply products or services in an international currency, prices are generally quoted for weeks or months without really knowing when the actual purchase will take place.
During this time, the exchange rate may fluctuate significantly, causing exchange rate risk. This exchange rate risk can sometimes only be confirmed when the actual ‘bill’ is paid.
How Do Currencies Affect the Value of Your Business?
With the possibility of exchange rate risk, a failure to protect your future transactions could expose your business to significant losses.
For example, if the exchange rate changes unfavorably between the time you make a sale or accept a quote and the time you receive payment or pay your supplier, you’ll suffer a financial loss.
Currency Risk Management Policy
Typically, businesses tend to fall into five categories (of currency risk management) when it comes to strategy on hedging currency risk:
- No Hedging Some companies accept currency risk as part of doing business internationally, hoping that positive and negative effects will offset each other in the long run.
- Systematic Hedging Some companies systematically hedge all (100%) of their international operations, seeing hedging as obligatory when doing business abroad.
- Partial Hedging Companies cover a certain percentage of their activities abroad based on their risk tolerance.
- Selective Hedging Companies only cover operations that require it, such as transactions in a less frequently used currency or amounts in excess of what is held in a Customer Foreign Currency (CFC) account in that currency.
- Case-by-Case Hedging Small to medium-sized companies often adopt this approach due to a lack of time or resources to develop a real currency risk policy.
- No Hedging Option or Facility Some companies are not fully aware of hedging and how it can help, or they lack working capital for margin deposits.
Instead of addressing currency risk decisions on an ad-hoc basis, it is significantly more advantageous for companies regularly engaged in foreign currency transactions to establish comprehensive currency risk management policies. The formulation of a currency risk management policy necessitates in-depth analysis and careful planning of future operations. This policy should undergo periodic reviews and is often implemented incrementally, enabling proactive consideration of essential questions and the preselection of suitable solutions.
Benefits of Effective Currency Risk Management
A currency risk management policy lets a company:
- Minimise the effects of exchange-rate fluctuations on its profit margins.
- Stabilise its profit margins.
- Develop a budget more easily.
- Establish a comfort zone when setting fixed-price contracts.
- Increase predictability of future cash flows.
- Maintain price stability of products sold in export markets.
- Temporarily protect the company’s competitive edge.
What to Consider When Setting Up a Currency Risk Management Policy
- What are my currency risk objectives?
- What kind of exposure should be covered?
- How accurately do I want to measure my currency risk exposure?
- What percentage of my currency risk exposure should be covered?
- Which techniques should or should not be used?
- Who will be in charge of implementing the policy?
How Merchant West Incompass Can Help
Our team of Treasury Solution experts is well-versed in assisting companies to design, implement, and execute a currency risk policy. We provide market-leading, transparent, and consistent charging as well as access to credit facilities to help implement forward exchange cover and required margins.
Get in touch via our enquiry form below, or call + 27 (0) 21 424 2936
Frequently Asked Questions
Currency risk management, also known as exchange rate risk, refers to the possibility of financial loss due to unfavorable movements in exchange rates. It is critical for businesses because fluctuations in currency values can significantly impact profitability, especially for those engaged in international trade.
Businesses can safeguard themselves from currency risk through various strategies, including ZAR billing, utilising forward cover contracts, and developing a comprehensive currency risk management policy. These strategies are essential in stabilising profit margins and predicting future cash flows amidst volatile exchange rates.
Merchant West Incompass plays a crucial role in assisting businesses to design, implement, and execute robust currency risk management policies. They provide expert guidance, transparent pricing structures, and access to credit facilities, enabling businesses to effectively manage and mitigate currency risk exposures.
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Currency Risk Management
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