All these risks emanate from trade across borders, which is subject to highly volatile exchange rates. Foreign exchange risk adds considerable risk to exporters, importers and competitors with imported goods in the local market.
Although financial institutions do play a crucial role in assisting traders in mitigating risks through the provision of trade and supply chain finance solutions, including letters of credit, foreign exchange rate risk is still one of the biggest risk factors faced by businesses.
Typically, overseas buyers of finished products would pay in their local currency, which the South African exporter then exchanges for rand before depositing it in his business bank account. However, while a sale transaction is in progress the value of a foreign currency may change relative to the value of the rand.
For the exporting company in SA, some of its export profits can be reduced, with the company incurring losses or export costs, which can significantly affect margins over time and reduce operating margins.
For example, a South African exporter thinks the pay-off from a trade transaction will be R1m from a shipment the company is exporting to Germany. But by the time the shipments of goods make their way overseas and the buyer takes delivery, the rand may have weakened against the euro and the exporter ends up only getting R910,000, with exchange rate costs accounting for R90,000.
The time lag between when the goods are exported and when the buyer takes possession is, therefore, critical.
Foreign Exchange Rate Risk Is Still One Of The Biggest Risk Factors Faced By Businesses.
If, on the contrary, instead of the rand weakening it appreciates suddenly against the euro, this means that by the time the South African exporter’s goods arrive at their final destination in Europe, the costs to the buyer must have increased. It may cost the buyer more in the local currency or the euro, to equal the rand value upon which the transaction was initially agreed.
The sudden increase in the final selling price to the buyer may even lead to the buyer in Europe no longer wanting to take delivery of the merchandise and in effect cancelling the deal.
Businesses need to constantly monitor currency variability.
A South African company can hedge and maximise benefits from currency volatility by simply opening an account in the country of import, enabling it to deposit the gains from exchanging currencies in an offshore account or in a local bank of the importing country.
This will enable the South African business to have a cash buffer to cater for and offset future depreciation of the rand.
However, local companies must ensure that they comply with the Reserve Bank’s foreign exchange requirements and its annual limits for companies to remit funds out of the country. The downside with this hedging method is that it’s hard to predict accurately when currency fluctuations will occur, or their direction and duration.
Domestic businesses can also take up currency forward contract agreements, which enable them to exchange certain amounts of rand for any foreign currency on a future date.
Forward contracts allow a business to lock in an import purchase of input or export sale of output at the current exchange rate, guaranteeing the proceeds of the transaction at an agreed price. The benefit of this type of agreement is the protection of the business against the risk of a weakening or depreciating rand.
However, the challenge is that if the rand should strengthen afterwards, businesses cannot profit from forward contracts since they are already locked into a mutually agreed exchange rate with the bank.
Another financial instrument available to local businesses is futures contracts, which are a commitment by the business to purchase currency in future at an agreed rate based on current exchange rates.
Although similar to forward contracts, futures contracts have an advantage over the former since there is a secondary market for them.
Companies can opt to sell their contracts to a third party before the agreed term of the contracts is up, or if they have a change of mind about the business opportunity, or if their businesses need more liquidity.
The snag with futures contracts is that they usually allow a range of forward exchange prices rather than a fixed point. Also, the contracts are only offered in fixed amounts, which may make it hard to hedge the exact amount a company may want through futures.
Currency options provide the exporter or importer with an opportunity – but not an obligation – to buy or sell a fixed amount of currency at a set price on or before a chosen date.
Currency options come with a strike price, which is the price at which the currency can be bought or sold. They also have an expiry date, after which the opportunity to purchase the currency option at the agreed price lapses.
However, the caveat is that these currencies or hedging strategies, including common spot deals, come with fees and commissions charged by banks or any party administering the hedging vehicle.
Irrespective of the route chosen, exporters and importers should assess the relevance of hedging against currency risks.
When in doubt, companies are advised to consult with their local banks for flexible and suitable cost-effective options.