to Cover or Not to Cover, that is the Question …
Factors such as globalisation, increasing international trade, regulatory and technological advancements have driven unpredictability to become synonymous with the 21st century.
These factors have contributed to making the various environments riskier today than ever in the past and therefore individuals, business owners and their representatives need to be concerned about the effectiveness of their management processes dealing with this uncertainty.
The study field of risk management is wide and, in many instances, adapted to specific environments such as foreign exchange risks.
Risk management refers to the ways in which risks that arise from the nature of business operations and unforeseen future events are dealt with. These events and their outcomes, which consist of a wide range of possibilities, are difficult to predict and the immediate thought then crosses one's mind, "if it is so difficult why do it at all?".
Some individuals focus only on the potential cost and/or negative impacts of risk whilst others believe that opportunity is explicitly imbedded in the concept of risk and risk management - you have all likely heard the term; risk and reward and that the higher the risks the higher the rewards will be. The generally accepted view is that; not managing risks will result in additional time and resources being allocated to rectify the adverse outcomes which implies unnecessary additional costs.
Effective risk management however not only proactively contributes to avoiding additional unforeseen costs but also assists in improving the competitive position and reputation of a business and even an individual.
From a financial perspective this means that the value of the business, you own or are working for, will improve. Managing foreign exchange exposures effectively therefore has a big role to play in not only controlling operating costs but also limiting the possibilities of huge swings in cashflows.
Foreign exchange is traded 24 hours per day; businesses however are generally only actively engaged in operational activities for about 8 of these 24 hours and therefore not in a position to react to emanating risk or opportunity. A risk management process therefore supports the organization by providing understanding of critical issues and a framework within which decisions and activities, such as the allocation of limited resources, can take place in a consistent and effective manner thereby reducing image risk and adding value to all the stakeholders.
This framework within which the organization acts can be referred to as the risk management mandate and process of the organization.
Exchange rate risk is a natural outcome for any individual or business who has money invested, income or expense flows in or to countries other than their home country. This must be viewed in the context that currency values fluctuate daily, by the minute and hour, are unpredictable and difficult to forecast. Exchange rate risk is therefore a potential gain or loss that occurs because of any changes in the exchange rate of any currency. Foreign exchange exposures are created when business takes place in a currency other than the home currency and therefore any company selling products or services abroad or who import goods or services has foreign exchange exposure. This exposure is however not restricted to transactions; driven by the ever-increasing trend of globalisation, a major competitor can go undetected in a foreign country and often, unaware of this, companies manufacturing and selling exclusively in their home country are exposed to significant levels of exchange risk.
To Cover Exchange Risk or To Not, that is the question.
A statement can be made that to not cover exchange risk is not much different to speculating. Why does this statement ring true?
Once we know a payment will have to be made, for an article we bought which was priced in a currency other than our home currency, our risk has already been opened. By not locking in the rand amount a view has been taken that the price will be more favourable on payment date than on the day the article was bought however, there is no guarantee that it will be. Does this not sound like speculation? An exchange rate cover (or hedge) could be taken to secure the foreign currency required at a fixed rate which ensures that irrespective of what happens with the exchange rate the rand required will always remain the same until payment is made. A hedge can be described as the creation of an underlying asset or position whose value changes, as the exchange rate changes, in the opposite direction as to that of the identified currency exposure. A perfect hedge would therefore be one whose value changes in an equal and opposite direction, resulting in a net zero change of the combined position. Hedging therefore protects the owner of the exposed asset, or liability, from losses but also eliminates the owner from any potential gains resulting from favourable changes in the exchange rate.
Before venturing into hedging exposures, a hedging philosophy should be decided on. This implies that business owners need to decide on whether, as a guideline; 1) they will be hedging all exposures, 2) be selective and only hedge some of their exposures or 3) not hedge any exposures at all.
Hedging transaction exposures are generally limited to the short-term as sales volume and exchange rate movement predictions over the long-term are uncertain and risky. A pre-cursor to the answering the questions raised is to determine the level of risk appetite the business has for exchange risks. This is a decision that always needs to be made with full consideration of the amount of money that can be lost without placing normal business operations under financial stress. Transaction exposures are generally managed through employing a set of internal or external techniques. From an external perspective these exposures are usually covered through making use of instruments, or commonly known as derivatives, provided by financial service providers such as banks and future exchanges. In its simplest form a forward exchange contract represents a first-generation derivative with some form of exotic option representing the more complex instrument. From an internal perspective technique such as home currency invoicing, matching currency receipts and payments and netting off subsidiary exposures, are all popular internal approaches to reducing the impact of exchange rate movements on business cash flows.
Forward Cover arrangements together with the likes of futures and options, are ‘Hedging’ tools. Hedging is a risk management strategy, used in limiting or offsetting the probability of losses from fluctuations in the price of commodities, currencies, or securities, or put another way, potential losses that a business may be exposed to, because of price changes on its assets, liabilities or future firm and ascertained commitments or accruals (e.g., imports, exports, service payments).
In South Africa, an Authorized Dealer can provide these ‘Cover’ transactions to customers, in order to secure an exchange rate today, for settlement sometime in the future and will charge a fee or a margin for the service. It is however very important to understand that forward cover contracts may not be established for speculative purposes, or as a means of circumventing Exchange Control Regulations. ‘Cover’ arrangements should be used to hedge a direct underlying foreign currency exposure, in respect of periods less than 12 months, or a firm and ascertained commitment for periods more than 12 months. Depending on the nature of the exposure, both businesses and individuals may avail of forward exchange cover.
From the discussion points made three main themes come to mind;
1) the notions that the risk lives in uncertainty, is integral to any daily activity conducted by a business and that as individuals we will never always be able to deal with or capitalize on it.
2) That any business, in their quest of maximizing value in uncertainty, requires an effective process, which as the minimum requires, the effective Identification, quantification, policy measures and reporting to deal with the risks and
3) that international trade with its resultant foreign exchange market and currency risks is here to stay and that within the concept of an effective risk management process the impact of movements in the underlying exchange rates can be managed to ensure that cash flow volatility is contained and ultimately value in the business is grown and protected.
It is also clear that FX risk management is not an exact science and need to be carefully approached in line with the individual and company unique circumstances and risk appetite. However, the perception that FX risk management is difficult and cumbersome should not act as a detergent to effectively manage exposures. This is an important skill that can be acquired – practice makes perfect!
Aligned with innovative technology tools, the BeztForex Team is highly skilled and well placed to assist clients with all their Foreign Exchange requirements, including the establishment of a Foreign Exchange Risk Management Framework to suit individual requirements and risk appetite.
Author: Herman Bezuidenhout
CEO - BeztForex