Managing Foreign Exchange Risk

The Kenya Shilling has depreciated by about 6% against all major currencies between April and last week with the exception of South African Rand and the Japanese Yen as tabulated below. The economic conditions responsible for this decline still prevail and one can only speculate when and where the exchange rates will eventually stabilise.

30-Apr-15 10-Jul-15 Movt %
US DOLLAR   94.60 100.74 6.5%
GBP   145.82 154.85 6.2%
EURO   104.87 111.68 6.5%
JAPANESE YEN  79.79 82.65 3.6%
INDIAN RUPEE 1.49 1.59 6.7%
SA RAND   8.00 8.09 1.1%
CHINESE YUAN  15.25 16.22 6.4%

A slump in domestic currency has the following effects which can adversely affect the profitability of the business:

  • Increase in costs for importers
  • Increase in cost of servicing foreign currency denominated debts
  • Increase in cost of capital investment where it involves importation of equipment

 

On the positive side;

  • Exporters benefit when converting foreign earnings to local currency
  • Domestically produced goods could become more competitive against imported products

The risk that the financial performance of the business may be affected by exchange rate fluctuations is referred to as foreign exchange risk. In this article, we look at some simple strategies that the business can adopt to manage this risk.

1. Develop a plan

Review the foreign currency needs of your business and establish a plan to minimise the effects of exchange rate fluctuations. Do not base your plan on currency speculations as this is not your core business. The aim should be to neither make a profit or loss but rather balance out the effects.

2. Hedge through a forward exchange contract

This is the most common method used in managing foreign currency exposure. The business protects itself from adverse movements by locking in an agreed exchange rate for each transaction. The downside is the business will not benefit from advantageous exchange rate movement as the contract price is locked.

3. Hedge through matching currency outflows with inflows

Where a business has both foreign currency inflows and outflows, one could try and match the timing of these receipts and payments. This is otherwise known as the perfect hedge. The practicality of this method is however limited due to uncertainties related to timing of cash flows.

4. Maintain foreign currency bank accounts

Maintaining foreign currency accounts for currencies that the business regularly transacts in eliminates the need for multiple currency conversion and the attendant risks. Foreign currency accounts could also help in managing the cash flow timing challenges in 3 above.

5. Borrow in foreign currency

Importers who rely on bank funding to pay for their imports could consider securing facilities denominated in foreign currency. The need for conversion from local to foreign currency is thus eliminated. This also affords the business the opportunity to determine the best time to make foreign currency purchases in the market.