31 JANUARY 2023
This content was first published in Research & Insights, a weekly publication of BusinessDay Nigeria's Research & Intelligence Unit, on 25 January 2023.
Why every business should implement hedging strategies
By Eyitope Owolabi
Let's begin by defining hedging?
Hedging can be defined as the trading of risk within the financial market. As savvy business managers, you do not want risks that are outside of your control to interfere with your daily operations. You also want to protect your company from the potential negative effects of market fluctuations.
In the Nigerian financial market, businesses are often faced with volatility relating to exchange rate, interest rate and commodity prices. So, by utilising hedging, managers can effectively transfer these risks from the business to the financial market to ensure that they are keeping earnings stable.
Can hedging be leveraged as a solution to macro-economic shocks?
Absolutely. One major concern we come across from business managers is that hedging introduces additional risks because it requires the use of derivatives. However, the reality is that when it is done right, it always reduces risks. The decision to not hedge at all means managers are choosing to regularly expose themselves to these macroeconomic shocks and betting that market movements will be in their favour or remain static over the period.
There is a quote by Nassim Taleb, a renowned statistician, economist, and philosopher, in his acclaimed book “Fooled by Randomness” that captures the point above: “no matter how sophisticated our choices, how good we are dominating the odds, randomness will have the last word”. The best hedging decisions are made when we accept market movements are not predictable.
With this in view, managers will need to do two things before making a hedging decision. Firstly, identify all the risks they are exposed to by defining the economic indicators that have a bearing on their business and then make an educated decision on what is acceptable risk. The point is not to have a business that always reacts to market, but a business that responds to a well-articulated plan. For that reason, it is important that the performance of any hedging strategy implemented must be evaluated against the goals set as a business and not market views. Secondly, familiarise themselves with derivatives as products or instruments for hedging and must educate key decision makers on the inherent risks when or if they choose not to hedge, highlighting the implicit cost or potential loss to the business. There is a general misunderstanding about the cost of hedging just being the direct transaction costs in transferring risks to the market while ignoring the indirect ones.
The goal should be about achieving a right balance between hedging benefits against its true costs.
What are the main hedging strategies available to businesses?
One established way of transferring risk for businesses is by entering into futures or forward contracts to lock in prices today to reduce market uncertainty between now and a future date. These contracts can be executed outrightly by managers or layered depending on the adopted hedging policy of the business.
There is also the use of swaps to exchange cash flows over a certain period to minimise price or rate fluctuations. Managers that are worried about the future changes in an asset class can execute swaps with financial institutions to reduce or neutralise it.
However, with these strategies, it is not a one size-fits-all approach to hedging as managers have a range of options to deal with, depending on their business risk tolerance. At RMBN, we provide advisory that are tailored to specific requirements and risk considerations. Based on our understanding, we customise and develop risk management solutions using the available hedging products in foreign exchange, interest rate, and commodity asset classes.
What are the key risk management activities in the Nigerian financial market and what are the businesses you work with currently requesting for?
As an emerging market and a developing nation, foreign direct investments play an important role in financing our economic development. Nigerian businesses are often faced with currency mismatches when accessing capital from foreign markets for either financing projects or facilitating international trade. Furthermore, the foreign revenues of the country are not diversified enough to be less dependent on crude earnings, and this also exposes the economy itself to high exchange rate risks. For this reason, most risk management activities or opportunities are concentrated around foreign exchange.
In the last year, we have seen an increase in requests and the execution of OTC FX futures contracts i.e., non-deliverable forward contracts. This trend is because of the diminished supply of foreign exchange and muted activity in the foreign exchange spot market, which altered market dynamics for financial intermediaries and market markers, narrowing down the hedging opportunities available. The businesses that were pro-active (around H1, 2022) and acted decisively in hedging their currency exposures, either partially or fully against potential exchange rate devaluation, locked in contracts at prices significantly cheaper than of the prevailing levels today.
That said, there is a lot of uncertainty, not only around the exchange rate, but interest rates as well. With the global slowdown and higher interest rate environment weighing on the market. While the use of derivatives to mitigate interest rate risk are not as commonplace like you have for foreign exchange risk, we have seen businesses with significant borrowings requesting for their floating interest rate liabilities to be swapped to fixed. And those with excess naira cash pursuing investment opportunities at the short end of the yield curve to maximise their cashflows.
What is your advice to businesses preparing for 2023?
It is essential to have a clearly defined hedging strategy in place for managing risk in today’s uncertain business environment. A well-designed hedging plan can minimise risk and reduce costs, protecting your bottom line and allowing you to focus on the aspects of your business where you have competitive advantage. RMBN can provide you with the knowledge and support you need to build an optimal risk profile and help your business execute effective risk management strategies. Don’t leave your business’s future to chance, let’s work with you to help protect your business.
Owolabi is RMB's Head: Structured Sales, West Africa
