CURRENCY RISK MANAGEMENT ESSENTIAL FOR IMPORTERS
WORDS: RICHARD PROTER, HEAD OF BUSINESS, FNB FOREIGN EXCHANGE
Currency risk management has never been more essential for importers and, especially in South Africa, importers need to take currency risk management very seriously. All companies of course should, but it’s particularly important for those that import because the rand tends to weaken very quickly, and this often goes hand in hand with a weak economy.
Practically speaking, importers need to plan for the potential that the rand is substantially weaker within weeks and that sales orders start to contract soon after. In general, this implies that importers should hedge and, usually, hedge quite significantly.
The ideal hedge ratio is company specific and depends on various key issues. Those that would indicate a need for a high hedge ratio include a low profit margin, a weak balance sheet, tight cash flow, a large importance placed on meeting the budget rate and limited ability to pass costs on. At the same time, cognisance must also be taken of what competitors are doing: in isolation. It might be optimal to hedge a lot – but that could at times backfire.
Having considered the above, companies should determine an optimal hedge ratio. This is the average hedge ratio that should be achieved over time. Generally, for importers this optimal hedge ratio will be very high, many times even closing in on 100%.
Many companies attempt to keep their hedge book at/or near the optimal ratio. However, three strategies that deviate from this are worth considering.
First, portfolio, also called bucket, hedging
The strategy here is simple: to hedge at different points, building up the hedge ratio over time, rather than hedging all at once. This averaging effect implies that you will never get the best rate and that you will never get the worse rate – a substantial smoothing effect.
Second, to vary the hedge rate, within pre-set parameters, depending on the market conditions
The back-testing work carried out by RMB/FNB shows that altering the hedge ratio can enhance returns. The way for importers to achieve this is by hedging more when the rand is strong (lock in good levels) and to hedge less when the rand is weak. This makes intuitive as well as mathematic sense, but the problem is it requires dealing with fear and greed. Similarly, hedge ratios should be increased whenever risks are high and reduced when risks are low.
Third, taking cognisance of market circumstances and levels
For example, by playing off technical support and resistance lines, using favourable movements etc. for entry.
In all cases, hedging activity can be advanced by talking with the RMB/FNB dealers to understand the market, risks, and valuations.