Introduction to FX Hedging
The term “derivatives” can strike fear into even the most seasoned finance executives in Ghanaian corporate establishments. This unease stems from similar hedging contracts that went awry in the gold mining industry during the early 1990s. However, the practicality of these instruments can no longer be overlooked, especially given the highly volatile market movements we have witnessed globally and, more pertinently, in Ghana.
These hedging instruments, often referred to as risk management products, are used by many corporate clients to mitigate market risk exposures. Market risks can take on different forms, such as higher interest rates leading to increased borrowing costs or sudden shifts in commodity prices that can have devastating consequences for businesses going through extreme price fluctuations.
In Ghana, the foreign exchange market has experienced increased volatility, leading to a growing concern among Ghanaian businesses about foreign exchange risks.
The primary goal of this article is first to clarify how foreign exchange risk arises. Second, it will examine risk management solutions and emphasis the importance of employing these tools to safeguard corporate entity earnings. Last, it will consider the advantages and any associated costs of these products.
The essence of this piece is not to provide a blueprint for hedging, but to underscore the disadvantages of neglecting market turbulence and the potential impact on a business. Often, businesses prefer to weather the storm, hoping for market calm. However, financial markets are rarely tranquil. In fact, periods of apparent calm often foreshadow significant turbulence.
Consider the year 2022, when the local currency depreciated by approximately 40% compared to the previous year’s marginal depreciation. This unexpected rollercoaster ride imposed a significant burden on businesses, leaving an indelible mark on history.
Hopefully, this article will serve as a foundation for discussions with banks like Absa, encouraging clients to take proactive steps to ‘insure’ their businesses against market volatility. Remember, like any insurance package, the aim is to provide protection during unprecedented market movements, which past trends indicate are probable.
How Does Foreign Exchange Risk Emerge?
Imagine a business owner in Ghana who imports and distributes electronic hardware, starting with a capital of GHS 120,000. At a hypothetical exchange rate of USD 1 to GHS 10, the business owner has spent USD 12,000 on hardware for the first cycle of imports.
Assuming one hardware item (e.g., a radio) costs on average USD 100 (GHS 1000), the business owner can effectively bring in 120 pieces of radios. If he sells all the radios in the next three months and each radio in Ghana sells for GHS 1500, all things being equal and holding out on any other cost assumptions, the business owner makes a profit of GHS 60,000 (which is the GHS 500 profit multiplied by 120 units) and this translates into USD 50 profit for each radio sold. In summary, the client will make USD 6000 profit plus his initial capital of USD 12,000, bringing the total capital to USD 18,000, all things being equal.
Should the business owner initiate a second round of radio imports, presuming the price per radio remains at USD 100 at the prevailing exchange rate of USD 1 to GHS 10, they would now be able to import 180 radios instead of the previous 120. Business is booming for this client on all fronts.
However, let us assume that at the point the business owner makes their Capital and Profit back, which is the total sum of GHS 180,000, the cedi depreciates around 8% against the USD and thus $1 is now 12 GHS. This effectively translates total cedi holdings to a mere USD 15,000, which is USD 3,000 less than the projected USD 18,000. At this point, the business owner has made a loss in terms of a cut to his profits.
Additionally, this client can no longer import the sixty (60) additional units and would have to settle for only thirty (30) additional units; a fall in expected inventory, which is a fall in revenue. Regrettably, the client relied on the ‘spot market’ to purchase foreign exchange. At that point, the client was a price taker and at the mercy of what that spot market can deliver. This spot market is the immediate exchange of currencies over which clients do not have control. There could even be extreme volatility or illiquidity; clients who need foreign currency urgently may not be able realise dollars immediately. The spot market ebbs and flows according to the whims and caprices of unpredictability. Through no fault of this electronic goods importer, he has taken on an impact despite his local business thriving. One can extrapolate the effect of foreign exchange risk on this business to cover other businesses which may involve the importation of medical supplies, ,construction materials for building projects, not to mention the buying and selling of automobiles in Ghana.
What precautions can a business take to avert these FX losses?
Certainty is the name of the game. Having the ability to guarantee future currency exchange rates offers peace of mind, which is crucial for a successful business. This can enable businesses to focus on their core mandate with no need to time the spot market, which can be a distraction. It is for this reason that Absa Bank specialises in providing various solutions which suit each business’s risk-reward profile. From the Forward Exchange Contract, providing certainty, to the Options contract ensuring flexibility, to the combination thereof to create a structured product to cater for the unique needs of the client – Absa Bank has all the unique solutions.
Forward Exchange Contracts
The first risk management product we will examine is the Foreign Exchange Contract (FEC). An FEC is a contractual agreement enabling a company to purchase or sell currency at a predetermined rate set now, for transactions that will take place in the future. Simply put, a client who does not hold Cedis presently to participate in the spot market (i.e., for an immediate exchange of cedis for say dollars) can agree on a price with the bank at which the future exchange will occur. Thus, instead of waiting for what the prevailing rate will be in the future (which, of course, could be adverse), he could agree to a forward price in expectation of his cedi liquidity. The advantage here is clear: the client secures foreign currency liquidity no matter the prevailing illiquidity conditions in the market and, most importantly, is guaranteed a fixed price no matter where rates are in the spot market when the exchange is due.
As an illustration, let us consider the electronic goods importer we previously mentioned, who has secured a forward rate of GHS 12.5 to USD 1 for the upcoming three months. This allows him to purchase USD in advance, anticipating the receipt of local currency as payment for the radios he sold. With an expectation of GHS 180,000 in the next three months, he has effectively secured a guaranteed sum of USD 14,400 by using the FEC. Assume the three-month maturity date arrives, and the current exchange rate is 15 USD to GHS. Due to the FEC’s stipulation that the bank must sell USD at a rate of USDGHS 12.5, the client remains advantaged by this lower exchange rate. The client has saved $2,400, which is equivalent to $14,400 at an exchange rate of $1 = GHS 12.5. This is the result of subtracting $12,000, which is equivalent to 180,000 GHS at an exchange rate of $1 = GHS 15. However, if the rates remain at the current level of USDGHS 12, the client will incur a loss of USD 600 (calculated as 180k/12 minus 180k/12.5, with 12.5 representing the agreed forward rate for future exchange). Nonetheless, this “loss” should be weighed against the security the client obtains by agreeing to this contract, especially given the volatile and often illiquid nature of the foreign exchange market.
It is crucial to emphasize that FECs provide services not only to importers but also to clients involved in exports. In simple terms, if a customer is expecting payment in a foreign currency, they can ask for a foreign exchange quote to facilitate the future sale of that currency. The advantage is also clear here because you can outperform the spot market by receiving a higher amount of local currency for every unit of foreign currency sold, especially when the market is calmer. For example, if the future rate for selling USD is set at USD 1 to GHS 12, while the current market rate is USD 1 to GHS 10, and the spot market remains at GHS 10, the client will gain an extra GHS 2 for every USD sold at the locked-in rate of GHS 12. However, this product has a drawback for exporters if the Cedi weakens beyond the quoted FEC rate. That notwithstanding, clients should focus on the guaranteed returns, which can aid in Financial Planning and reducing the stress of operating in uncertain conditions.
FX Options
The trade-off of an FEC contract to both the importer and exporter is obvious. Corporates who value flexibility may find it extremely inconvenient when they are unable to take advantage of a spot market that offers a better price than the FEC rate. The FX option is a contract that provides a high level of flexibility, allowing easy participation in favourable market movements. The electronic goods importer in our earlier examples might be concerned about obtaining a higher exchange rate that might not materialise. This could result in higher prices for his radios, as he would include the cost of the foreign exchange conversion in the unit price, making his Business less competitive.
The client may face reduced returns if they do not pass the cost on to customers. For clients seeking more flexibility, the FX Option is a better choice. An FX Option gives the right, but not the obligation, to buy or sell a currency at a set price in the future. This allows the client to act only when it is favourable and walk away when it is not. For example, if our radio importer locks in an FX Option to buy USD at GHS 12.5 for GHS 180k in 3 months, and the market rate at that time is USD 1 to GHS 13, they can enforce their right to buy at GHS 12.5 to USD 1, as it is more favourable. If the rate is USD 1 to GHS 12, they can walk away from the contract and buy at the better rate of GHS 12 to USD 1. This flexibility comes at a cost, known as a premium, which usually hovers around 5% of the contract’s value, depending on market volatility at the time of pricing. After paying the premium, the client is guaranteed that they can select the most advantageous option regardless of market conditions.
A key feature of option contracts is that clients can choose a strike rate that suits their business needs. For example, if our radio importer prefers a rate of USD 1 to GHS 10 where the market is quoting USD 1 to GHS 12 for example, they can pay a premium to lock in the more favourable rate. This will have a higher premium, as buying USD at GHS 10 to the dollar is more favourable than GHS 12. By doing this, the client can secure their desired rate without adversely compromising their returns or profits. Like FECs, FX options can be used by both importers (who buy ‘Call options’) and exporters (who buy ‘Put options’). The exporter, like the importer, can choose to walk away if the spot market offers a better deal. This adaptability is perfect for companies ready to spend more for greater flexibility.
There are many variations of call and put options that can be combined to create customised structures based on a client’s risk and reward preferences. For instance, a participating forward on the one hand allows for a client to secure an FEC rate and still take advantage of positive market shifts without incurring a premium—perfect for clients who would rather avoid upfront hedging costs. A zero-premium collar on the other hand also offers similar participation structure by setting a cap and floor, which protects the client within a specified range without requiring any upfront fees or premium. Lastly, enhanced structures like seagulls provide extra protection or participation if the client has a clear view on where rates are heading and wants a structure to match that view, while still offering protection if the view does not play out.
Conclusion
Absa Bank offers products that allow for meaningful discussions with clients concerned about the impact of currency volatility on their businesses. The key is to engage the bank early to put measures in place that can help mitigate market risks. One way to start managing risk is by establishing a framework for addressing it within your business by implementing a Hedging Policy. This policy outlines the company’s risk management objectives, the types of market risks in scope (such as foreign exchange, interest rate, or commodity price risks), the hedging tools to be used (a simple FEC, or an Option), the proportion of exposure to be hedged (50% or more or even less), and who will manage the hedging strategy. By having this simple document, a company can establish a blueprint in guiding it to secure stability and to continue operating despite market uncertainties. At Absa Bank, your story does matter, and we encourage you to reach out so we can help you develop a tailored, cost-effective risk management strategy.
