While companies insure their properties and assets against contingent or uncertain losses, often, they neglect to protect their ultimate goal: profitability and profits. Foreign exchange risk is the exposure to potential financial losses due to the fluctuations in the exchange rates between currencies. Companies engaged in importation and exportation of goods and services need to pay enough attention to exchange rates as the value of goods and services has become highly sensitive and unstable with constant fluctuations. Companies that trade locally must also be aware of changes in the exchange rates as they would have an indirect impact under a broader economy. If revenue and costs are earned and spent in different currencies, there is an underlying degree of financial risk. Exchange risks can be mitigated by using various tools, techniques, and resources to reduce unfavorable effects on a company's cash flow.
Impact of exchange risks
Statistics from the FMDQ group (NAFEX), the official CBN trading window just like NIFEX, which uses trimmed arithmetic mean, revealed that the Naira depreciated against the US Dollar, losing 0.03% ($/?0.11) to close at an average of $/?411.49 in August 2021 from $/?411.38 recorded in July 2021 (see chart below). Further, the Naira traded within a range of $/?410.80 - $/?412.00 in August 2021 compared to $/?410.38 - $/?411.75 recorded in July 2021. However, the unofficial (parallel) market showed the Naira traded at about N560 at this time.
The volatility in exchange risks and losses have increased unease about the going concern and liquidity risks over the years. This can also be deduced from the reported loss of foreign investments for the past five years. Although the Central Bank of Nigeria has not been able to curb its effect completely, businesses need to 'arm' themselves in the face of looming danger.
There are three critical foreign exchange risks that businesses are exposed to: transaction, translation, and economic risks.
Transaction risk applies to completed transactions either made or received in foreign currency but yet to be settled. The risk is that the currency may fluctuate, harm the company, and coerce them to exchange currency under less favourable conditions than initially budgeted. The risk may occur well before the period when the actual currency conversion takes place, especially for businesses that share their price list in advance and businesses that negotiate prices of goods and services contract by contract. To illustrate this further, a bottling company in Nigeria (Klux Ltd) agrees to pay in USD for a bottle molding machine manufactured by a company in China with payment due in 30 days. If the exchange rate for Naira weakens during the 30-day period, Klux Ltd would have to spend more Naira to buy the dollars to be paid to the Chinese company.
Translation risk is a change in the financial position (assets, liabilities, equities) due to exchange rate changes. This is predominant with multinationals that prepare consolidated financial statements, and this is because they must translate their international assets and liabilities from foreign currencies to local currencies. These risks generally pose a threat in presenting unexpected figures upfront. For example, when Coca-Cola FMCG wants to consolidate financials, profits from the Nigerian branch can become a loss upon translation to the Group's currency due to fluctuations in currency.
Economic risk arises when a local currency strengthens, and companies become less competitive than their foreign counterparts. This is largely influenced by macroeconomic factors, geopolitical factors, and hurricane.
Mitigating these risks
- Identify your needs and evaluate exposure to exchange risk. Understand the currency market, have a risk management personnel monitor the trends and how they affect your business's overall exposure.
- The exposure can be avoided by selling only in Naira; however, this may result in losing business opportunities for expansion to willing competitors.
- Have a policy!! "Many CFOs or FDs have too many responsibilites, so when foreign exchange markets move significantly, Boards can be very unforgiving especially when the rate drops by 10% or more but the risks were not hedged. On the flip side, if the rates go the other way, the CFO may be asked, 'Why did you hedge?' Having a foreign exchange policy signed off by the Board removes all these emotions!" Chris Towner, Managing Director, HiFX.
- Adopt the most straightforward non-hedging risk technique by pricing the sale in a foreign currency in exchange for cash. Another would be to use spot payments. This is when the buying and selling party agree to pay using today's exchange rate and settle within two business days.
- The company can also net foreign exchange receipts with foreign exchange expenditures to minimize risks. Opening a domiciliary account can achieve this.
- Hedge with a forward contract; a forward contract is a special contract between two parties to trade an asset at a pre-determined price sometime in the future. There are no fees or charges for a forward contract.
- Hedge with currency swap; this is a derivatives product and is used when there is a differential in interest rates between countries. For example, interest rates in Nigeria are higher than interest rates in Switzerland. Hence it would be cheaper to get loans in Switzerland. When a Swiss-based company seeks a loan in Nigeria, the two companies can initiate a currency swap and agree to eliminate interest rate and exchange rate risk.
- Undertake a Vanilla option which allows you to trade foreign currency at a date and pre-determined rate. Like insurance, the option buyer must pay an explicit fee, a premium. Importers are protected against currency appreciation through a call option; meanwhile, exporters are protected against depreciation through a put option. On the other hand, if the value of forex appreciates, the exporter simply lets it expire and sells at the spot rate, although the premium would be relinquished.
- Quantify the effect of the risk and create a flexible budget with an allowance to absorb this effect.
- Consult a finance expert if it gets too complex. Mazars is adequately equipped to assist with this.
It is strategic to have structures in place to repel these risks and losses. However, these techniques are mostly recommended for use in competitive markets or when foreign buyers insist on purchasing in their local currencies. The effects of the volatility cannot be completely expunged but managed. Hence, Companies need to ensure they have the best mix of strategies, re-evaluate strategies for efficiency, and better explore the hedging matrix.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.