What Is Currency Risk and How Can It Be Managed?

Background 

According to the IMF, the 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.(https://dailyinvestor.com/finance/14509/rand-volatility-limits-south-africas-growth/)

With this inherent volatility comes currency risk, for all South African businesses, that deal in international trade and different (non rand) currencies.

What is currency risk?

Currency risk, otherwise known as exchange rate risk, occurs when there is a change in price of one currency in relation to another.

• Currency risk is the possibility of losing money due to unfavourable 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 have an impact on a company’s accounts receivable and payable.

Selling or buying internationally means making transactions in foreign currencies. However, currency rates change rapidly. Depending on how much a rate rises or falls, your invoice may be higher or lower. For example, when the exchange rate rises, you’ll have to pay more to your suppliers. When it drops, your sales will bring in less than expected. This is called currency risk.

EXAMPLES OF CURRENCY TRANSACTION RISKS

To fully understand the concept, let’s take a look at two examples: one, a South African importer, the other, a South African exporter.

1. 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. But, 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.

2. For an exporter

A South African exporter is making 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. 

When exchange rate risk occurs 

When companies enter into contracts to supply products or services, in an international currency, prices are generally quoted for a period of weeks or months, without really knowing when the actual purchase will take place. 

During this time, the exchange rate may fluctuate significantly, causing an 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 unfavourably 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.

How do businesses protect against currency risk?

There are a number of strategies for alleviating exchange rate risk, below we touch on a few different strategies:

• ZAR billing 

One of the more straight forward ways 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 and as such ‘moving’ the exchange rate risk to the purchaser.

There may be some resistance to this as many companies prefer to deal in a more ‘popular’ currencies such as USD, Euro or GBP.

In terms of 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.

• Disclaimer - same day exchange rate 

This is sometimes used by importers as a method of trying to avoid exchange rate risk. In essence when the importer quotes the local price (ZAR) to his client, they add a ‘subject to’ clause. This ‘subject to’ clause pertains to the quoted ZAR price being ‘subject to change in line with prevailing exchange rates’ on the day the invoice is paid.

This method does have some drawbacks:

• Clients are not keen on committing to an unknown price when ordering.
• Clients often see the exchange rate risk as the responsibility of the importer and not themselves.
• It can be admin intensive.
• It is not a precise science as currency rates can fluctuate significantly in hours or even instantly on market news.

• Forward cover 

There are a number of different types of forward cover contracts that can be investigated in order to identify which may suit a business’ individual needs, 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’ time. Since the projected costs have been established in South African rand, if the U.S. dollar were to lose value against the South African 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.

Currency Risk Management Policy 

Typically businesses tend to fall into 5 categories when it comes to strategy on hedging currency risk:

1. No hedging

For some, doing business internationally means accepting currency risk. They know that some times the exchange rate will move in their favour, and other times it won’t. They hope that the positive and negative effects will offset each other in the long run. 

2. Systematic hedging

Some companies systematically hedge all (100%) of their international operations. In a way, they see hedging as obligatory when they do business abroad.

3. Partial hedging

Between these two extremes is another option called partial hedging. It is more common for companies to cover a certain percentage of their activities abroad, based on their risk tolerance.

4. Selective hedging

Selective hedging is a form of partial hedging: A company only covers the operations that require it, such as transactions in a currency that it uses less frequently or for amounts in excess of what is held in a CFC account in that currency.

5. Case by case hedging 

Small to medium sized companies often adopt a case by case approach to hedging. Generally due to a lack of time or resources to develop a real currency risk policy.

6. No hedging option or facility 

Other companies are simply not fully aware of hedging and how it can help. In some cases the business would like to hedge but lacks working capital for margin deposits. 

Instead of addressing currency risk decisions on an ad-hoc basis as they arise or neglecting active currency risk management altogether, it is significantly more advantageous for companies regularly engaged in foreign currency transactions to establish comprehensive guidelines for managing this risk.

The formulation of a currency risk management policy necessitates in-depth analysis and careful planning of future operations. Naturally, this policy should undergo periodic reviews and is often implemented incrementally. Nonetheless, having a policy in place enables proactive consideration of essential questions and the preselection of suitable solutions, preventing the need for urgent reactions to avoidable delicate situations.

Failing to manage currency risk is akin to speculating on the future of your business while counting on market conditions to always align in your favour. Effectively shielding against currency risk can strategically reduce your exposure to market fluctuations and potentially confer a competitive edge.

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?

Common Q and A’s

Q1: Why is currency risk considered an inherent part of international business?

A1: Currency risk is inherent in international business because transactions involving foreign currencies are common. However, foreign exchange rates can fluctuate rapidly, leading to increased costs for a company when rates rise and reduced revenue when rates fall. This volatility can make it challenging for entrepreneurs to maintain profitability.

Q2: How can currency risk affect a company's future profit and competitiveness?

A2: Currency risk can impact a company's future profit and competitiveness over the medium or long term. Failing to hedge against currency risk can result in significant losses. Even minor fluctuations in exchange rates can have a major impact on profitability, potentially leading to substantial disadvantages when making sales or payments.

Q3: What methods are available to protect a company from currency risk?

A3: There are various methods to safeguard against currency risk. These include internal and contractual techniques, as well as financial solutions. Financial solutions allow businesses to partially or fully cover currency risk based on their risk tolerance and the company's financial health. Partial hedging, which covers only a portion of potential risk, is a commonly used approach.

Q4: What are some common hedging solutions available to businesses for managing currency risk?

A4: Businesses have access to various hedging solutions, each with distinct characteristics. These solutions often require expert advice but can be highly effective. Examples include forward contracts, swaps, options, collars, and more. Many of these solutions are based on the forward exchange rate, provided by financial institutions for buying or selling foreign currency at a predetermined future date.

Q5: What course of action can be taken for effectively managing currency risk?

A5: One course of action for managing currency risk is to establish a currency risk management policy. This policy helps a company proactively address currency risk by defining strategies and guidelines for risk management. It ensures that the company is prepared to deal with currency fluctuations and minimise their impact on profitability and competitiveness.

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 are also able to 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 contact page, online chat or call + 27 (0) 21 424 2936.