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South Africa, with a population exceeding 50 million, has a growing consumer base and middle class, making it an attractive market for local and overseas companies. Given how volatile the South African Rand (ZAR) can be, the impact on a company with ZAR exposure can be significant—positive or negative.
In deciding on an appropriate hedging strategy, treasury will need to consider at least the following:
Does the company need to hedge?
Firstly, it must be determined how bad can things get if the ZAR moves against the underlying position and no action is taken. The impact of natural hedges and correlations in the portfolio must be taken into account, but keep in mind that correlations do not always hold. The likely impact on at least the following must be determined:
- The ability to deliver on corporate objectives
- Credit rating, and with it, funding access
- The ability to maintain covenants and a dividend.
Secondly, once the numbers have been run, the different objectives with regard to the hedging decision must be considered, for example:
- Lock in the budget rate (provide certainty of cash flows)
- Ensure the company is at least cash flow neutral on a monthly basis (protect the margin)
- Smooth the earnings and reduce cash flow volatility (easier to manage liquidity)
- Protect a break-even level (covenant)
- Protect a worst case outcome (funding facility not sufficient anymore).
How much and how far forward to hedge?
The above will then lead into a more specific decision on how much and how far forward to hedge. The certainty of exposure is also important, i.e., is it a committed or a forecasted exposure. Typically the exposure will be less certain as time increases. If a defensive hedge is done (e.g. protect a covenant) or if a company has to protect its margins in order to continue operating, it will typically hedge a higher proportion of exposures and for a longer period. The company will in essence have to take into account how much risk it is can take (risk tolerance) versus how much risk it wants to take (risk appetite).
Can the company live with the decision?
Management must satisfy itself that whatever the outcome of the hedging decision, it can live with it. Often decisions will not be taken for fear of how shareholders or investors may react if it does not turn out to be good.
The cost of hedging
The interest rate differentials between the U.S. and South Africa are high at 6.0-6.5 percent across the curve. This benefits the buyer of ZAR (e.g. SA exporter that receives U.S. dollars), but it is a cost for the seller of ZAR (e.g., U.S. company with ZAR revenues).
When to hedge?
This inevitably leads to the question on market timing—normally, treasury should not try to time the market, as the reason for hedging is not speculation, although it is natural to try and pick the best rate possible. With a volatile currency like the ZAR, waiting can prove either to be a very good or a very costly decision.
How to hedge
This involves the following:
- Instruments to use: There is a well-developed forward market for the ZAR, with tenors above 10 years possible. Forwards will typically be used if certainty of the hedging outcome (cash flow) is required, or if there is a strong view on where the currency will be trading. Options can also be used and the market is well-developed. Options will typically be used if knowing the maximum loss potential upfront is important (purchased option), protecting against a worst case whilst having upside potential, or if the view is the ZAR will trade in a range but want downside protection (use a collar).
- Methodology: The hedge can be implemented in a number of ways, for example a static, rolling or layered approach can be followed. By layering in a hedge, the hedge rate is averaged in and this is makes it a favored approach of many companies.
With whom to hedge
This involves the decision on which bank will be the counterparty. Considerations can include:
- Spread between existing core relationship banks, or going for best pricing outside this group
- Bank counterparty risk and/or credit valuation adjustment impact
- Sufficient lines must be in place, including confirmation if margin calls or some type of collateral is required. Any request from a bank to post margin or collateral will probably negatively impact on the decision to hedge, but this could be a function of the credit quality of the company.
- Does the company have the in-house expertise to hedge? Outsourcing the hedge execution and management may be an option so that the company can concentrate on its core duties.
- How will the deals be captured, e.g., a treasury management system?
- Will accounting treatment objectives be met?
In essence, hedging ZAR exposure is not much different from hedging any other liquid currency. There are some unique exchange controls to adhere to, but these are manageable with proper preparation and with the assistance of the local banks.
Riaan Bartlett, CTP, is a treasury and finance executive based in Pretoria, South Africa.
A longer version of this article will appear in an upcoming edition of AFP Exchange.