FX risk management in a time of crisis

Now is not the time to create more or new risks within your business says Wauko's David Irish.

In this unprecedented and extraordinary time of significant uncertainty and volatile foreign exchange markets, we felt it important to provide some guidance and insights into how foreign exchange risk management should be approached in a time of crisis.

Firstly, take out your foreign exchange policy and read it; thoroughly. And review the key factors and parameters that were analysed in order to determine the policy. If you do not have a foreign exchange policy, put one in place urgently.

Secondly, are you managing foreign exchange risk as part of your holistic cash flow cycle or are you managing it on a standalone basis? Your foreign exchange policy should be part and parcel of a robust treasury management policy that is created to optimise and protect the cash flows in your business. If you do not have a treasury management policy, put one in place urgently.

Just how significantly has the South African Rand been impacted by, mainly, the COVID-19 crisis and the Moody’s ratings downgrade?

Next, we need to look at the impact of these market movements on your business and the impact this has on the decisions you are making.

One important piece of advice during times of a significant shortage in liquidity, countries being locked down, many businesses closing and worldwide job losses on the increase; “Now is not the time to create more or new risks within your business”.

Let’s look at this in more detail:

We realise that there will be some of you that will still want to take on more risk, regardless of whether this may reduce your returns or put your business under even more pressure.

BUT if you do want to follow this approach be sure that you have all the facts before making this decision:

Our advice would be to reduce your specific uncertainty as far as possible during times of crisis. Risk mitigation should not only be applied during periods of crisis, but rather on a consistent basis in order to enhance the sustainability of your business and its results.

No-one can predict what the future holds (not even in non-crisis periods). We have not found a single analyst that is prepared to predict how long this crisis, or the impact thereof will last; how far the weakening of the rand may still have to go, or when we may see strengthening of emerging market currencies (including the ZAR) when market liquidity is restored.

We believe you should rather be determining what business decisions you should be making in the light of the state of financial markets.

Factors to consider:
We provide you with two examples of factors that may impact your business in a period of crisis, but that should form part of your overall risk management plan; and thus also be considered when evaluating and formulating your foreign exchange and treasury management policies:

1. Many countries are closing their ports, either to certain product types or in their entirety:

2. How “essential” is your product to your customers and their markets? Are you at risk of facing order cancellations and if so, how could it affect you?

These two examples indicate how important it is to consider the impact on your holistic (full) cash flow cycle when making FX decisions. There are many more factors to consider and they may differ from one business to another.

Analysing your operating cycle can help you understand the exact nature of your business’s operations and the unique characteristics related to the marketing, sale, production and delivery of your product or service. This analysis can also help determine how and where your foreign exchange risk appears and how long it remains.

With the level of volatility in the foreign exchange markets at present exposing yourself to more risk may be fraught with more dangers than you think.

Over the past month, the volatility of the rand against our major trading partners has increased significantly, both on a daily and hourly basis; see USD ZAR graphs below:

This is compounded by the fact that the extent of the variance in 2020 is being calculated off a significantly higher base (rate of exchange).

Compare these numbers to the risk margins, loss ratios and adjustment intervals we built into your policy. In all likelihood you would need to widen these parameters significantly in order to benefit from the upside but as we have shown this could just as easily turn around and bite you.

Looking at the daily and hourly directional volatility charts (this plots the percent of the period variance of the opening rate to the period low versus the opening rate to the period high) it is clear that any increase in cash flow at risk can on average; just as easily result in an increased loss as an increased profit. Although the daily directional volatility during 2020 has leaned towards the high; on an hourly basis it has hardly moved.

From this analysis we conclude that the most rational approach to these turbulent times is to stay the course and continue to apply the policy that hopefully demonstrated to you will provide an optimal result over the long term. Remember, if you did your data analysis properly in formulating or updating your policy it would have included Nene-gate, the build-up to Nasrec 2017, Zuma’s ousting and the waning of Ramaphoria, etc.

If anything, the one parameter you may want to revisit is the risk margin applied to determine your reference rate for costing purposes.

And in your calculations do not forget to factor in the effect of forward points.

If after all this, you still wish to adjust your foreign exchange policy please do not do it without expert advice.

Pieter le Roux CA(SA) contributed to the preparation of this report/article.