The issue of Forex fluctuations and associated risk is constantly affecting business dealing in global markets as highlighted by the Association of Chartered Certified Accountants. The global agency based in London revealed that 83% of SMEs trading globally lost or gained $ 1 million in 2012 to Forex fluctuations, which is a substantial figure for any business that can make or break them.
Take for example – Pizza XYZ Inc, a company in the US decides on open a branch in Australia, they invest $10 million USD in 2011 when $1 AUD was equal to $1 USD, making an investment of $10 million AUD and In July 2020, they decide to sell their business in Australia for $15 million AUD. In a normal world without FX fluctuation, that is a profit of $5 million AUD or USD but in reality, due to FX fluctuations, they lost $4.2 million USD from their profit at current rate of $1 AUD=$0.72 USD.
These fluctuations are affecting businesses in emerging markets even more than those in the US or Europe – especially in nations of Africa which export raw materials such as Gold, Oil, and Copper, etc. and import almost everything from consumer goods, fertilizers to engineering goods.
According to a report by Forex Brokers SA, African Countries like Nigeria & South Africa have seen their currencies devalue by almost 33% and 23% respectively since the start of 2020 due to Covid-19, which has adversely affected both their exports and imports. Nigeria which mostly depends on income from exports of Oil & Cocoa has seen drop in forex reserves as their currency Naira devalued from N360 to N480 and global demand fell for Oil, this has in turn put pressure on their imports making them expensive for the local businesses & consumers that rely on them.
One can clearly see how businesses & economies can struggle due to FX fluctuations, but as a business dealing internationally, there are a few FX market hedging tools & options that can help you mitigate these risks to some extent.
Managing your Forex Risk
Managing the Forex risk for your business is not as simple as it may appear. Several diverse factors determine the extent to which Forex fluctuations impact the cash flow for businesses. These include the internal competitive behavior of market segments to macroeconomic trends.
Let us briefly examine the 4 steps for managing Forex risk for your business:
1) Review your Business Cycle
You must assess the business operating cycle for identifying the presence of Forex risk. It will assist you in determining the sensitivity of your profit margin to currency fluctuations.
2) Calculate your Exposure to currency risk
It must include exposure to risk before finalizing a transaction, purchase, or deal. The actual risk after completing the transaction must also be calculated. You can determine the hedging level needed for your business after assessing the post-and pre-transaction risk.
3) Hedge your risk using the following tools/strategies
You can make use of currency hedging for eliminating the Forex risk for your business while conducting international business. It is an act of entering a financial contract for safeguarding against probable or unforeseen fluctuations in rates of currency exchange.
a. Currency swaps
It is a strategy wherein you swap the principal and/or interest on a loan in one currency for the principal and/or interest in another. The rates of interest can either be variable or fixed.
Currency swap permits you to secure a rate of exchange and safeguard from adverse fluctuations. Meanwhile, you can also benefit from favorable fluctuations.
b. Spot contract
This hedging tool permits you a currency exchange at an effective market rate. These trades normally settle within 2 business days.
c. Range forward
This hedging strategy is devised for providing settlement of funds within a price range. It requires 2 positions in the derivatives market that creates a range of settlement at given time in future. You are permitted to fix the rate of exchange in advance that eliminates ambiguities of currency fluctuations.
d. Forward contracts
It permits you to lock in a sale of export or import purchase at the current rate of exchange. This ensures your transaction at the price agreed upon.
For instance, this can be an agreement wherein you agree to sell a commodity to the customer in the future at a fixed rate of price.
e. FX Options
This is a hedging tool that offers you the right but not an obligation. It is for exchanging an amount of cash in one denomination currency into another currency on a specified date at a pre-determined rate of exchange. These are available as Forex Trading derivative on an exchange like Nasdaq or FTSE or JSE and is popular among businesses & traders looking to speculate or hedge the risk.
f. Debt operations
It involves the borrowing of foreign currency. You can borrow currency in the amount that you expect to receive in the future. Then, you deposit it by exchanging into local currency that hedges the risks of the exchange rate. You can then use it for paying the debt after receiving the foreign currency.
g. Multi-Currency Account
You can also have multi-currency accounts as a hedging strategy for keeping the currency of your transaction. As an exporter you can for example keep USD reserve and pay the suppliers using this reserve.
h. Focusing on net exports strategy
One of the best strategies for managing Forex risk as a business is to focus on exports. Increased exports will enhance your Forex reserves. It will also boost the local economy and create more jobs locally as well.
The majority of the above hedging tools are available through Banks or Exchange or Derivative Markets.
4) Create a Forex policy and stick to it
Businesses regularly dealing with FX should consider their business metrics and make a plan to form a company FX policy to deal with the risk.
An effective Forex policy starts with a clear business strategy and clarity on business objectives. It should determine all the above key metrics – be it flow of cash, asset values, EBITDA, and ratios for coverage of debts and interest.