The year 2016 marked a season of inflation and scarcity for various commodities; tomatoes, pepper, imported rice and not forgetting the world’s most desirable currency, the USD dollar. The free fall of the exchange rate of the Naira to the dollar has been a sore point in the political discussions and an index, in tandem with price of PMS and electricity supply, for judging performance of the current Government. The enlightened populace has been waiting for the Central Bank of Nigeria’s pronouncement on how the new Foreign Exchange (FX) regime.
This article is simple to explain how companies and business owners can hedge against FX fluctuations which affect their businesses.
Hedging as defined by the Oxford Advanced Learner’s Dictionary means to protect yourself against losing money. Therefore, I will attempt to explain how hedging can be done by business owners due to the fluctuations in FX rate.
Sometimes last year,A few days back, I stopped by the roadside sales woman on my way home to buy a bunch of plantain. While still expressing shock at how costly this small bunch was, a neighbour of mine who met me there was regaling me with stories of how expensive tomato wasis and how a piece wasis more costly than an apple – I hadve seen that on twitter, then I remembered that my dear wife had hedged against this risk by buying a basket full of tomato’s months back at Mile 12 market and we don’t have to worry about tomato prices in the medium term – Good woman.
So what are the hedging tools we might see take centre stage in the Nigeria market.
Firstly, the Fisher effect
The International Fisher effect postulated by American economist Irving Fisher shows the relationship between interest rates, inflation rate and exchange rates. Basically, one can predict the future exchange rate of a country’s currency against a reference country currency. So let’s assume that the Naira currently goes for N200 to the $ and the year-on-year inflation for Nigeria and the USA is 10% and 5% respectively. The expected exchange rate for Nigeria at the end of Year 1 would be N209.5/$ (N200 x 110/105). This simple theory also has a relationship with the Interest Rate parity theory which states that expected future movement in Interest rates can also use be used as a basis for determining the future exchange rate at a forward date (assuming variables related to the reference currency remain static). Therefore if the current N/$ exchange rate is N200/$1 and Interest Rates are expected to rise from 10% to 15% in the next year, the future forward exchange rate would be N209.09/$1 (N200 x 115/110). However, we don’t live an ideal world and exchange rate movements are not as simplistic as this.
Now, Hedging Options
It’s June 30 2016 and Mr. Alao needs $100,000 to buy a tractor by December 31 to for use on his cocoa plantation by 1st January 2017. The current dollar buy rate is N200 and therefore Chief Agbabiaka would need N20,000,000 today to buy the tractor. However, he is concerned that using N20m would not be a wise option since he could invest this amount in treasury bills at 10% and just keep it in a fixed deposit account till he actually needs to sell it in December 2016. Worse still, he might not have the N20m to trade with at this time, what can he do?
1. FX Forward Contract
This is used when you want to hedge your foreign currency risk in a simple way up to a predetermined worst-case exchange rate. This is done by exchanging a sum of money into a different currency on a particular date (or within a particular timeframe) in the future at a predetermined exchange rate.
In this case, Mr. Alao goes to the Bank and enters into a forward contract to buy $’s from the Bank on December 2016 at a certain rate. The Forward Rate is agreed at the time the contract is entered into (June 30) and we assume this is N220/$1. It’s unlikely that the Bank would enter into an agreement at the current spot rate as the impact of Interest Rates and Inflation would imply a change in rates at a future date. Mr. Alao assess that this rate is fine and signs the deal. On 31 December, he goes to the Bank collects his $100k and parts with N22m – deal closed. If the rate in the market is now N240/$1, Chief has saved a cool N2m but if it’s the converse and rates are still at N200/$1, he’s lost N2m. However, he’s sure of his cash outlay well ahead of time and therefore reduces the risk of uncertainty in future exchange rates.
2. FX Options
Moving from the first scenario in No. 1, Mr. Alao can take advantage of an appreciation in exchange rate by entering into an Option agreement with the bank. So he says “Mr. Banker, I agreed to buy dollars from you in future at N220 but if it’s N210 in the market, I lose N1m”. So Mr. Banker says he can actually enter an agreement with the bank at a lower rate at the future date but would have to pay an option fee. So he agrees to pay N200K today for the risk the Bank will take on future appreciation in exchange rates. Therefore if the Naira depreciates to N210/$1 in the future, Mr. Alao’s outlay is N21,000,000 (N210 x $100k).
However, he has paid an option fee upfront so his total outlay is actually N21,200,000 which translates to an effective exchange rate of N212/$1. If the Naira/$1 exchange rate depreciates to N240/$1, he simply doesn’t exercise this option and goes ahead to buy at N220/$1 which makes his effective cash outlay as N22,200,000 and effective exchange rate as N222/$1.
An effective cash flow management through hedging can greatly reduce the probability of a company suffering from currency issues in the future.
Please note that the above analysis is done from the perspective of the business owner.