MOST small and medium enterprises (SMEs) are losing money in foreign currency risk after failing to hedge rightly. This has led to a reduction in their profitability and creating a dilema in dividend decisions.
When firm’s profitability dwindles, it faces three major dividend decisions including declaring all the earnings and paying out to shareholders, to retain all the earnings to finance future investments or declare and pay out as dividend a portion of the earnings.
Earnings also affect the price-to-earnings ratio, which measures the value of stock price. Lower earning means share prices should go down.
The way businesses can mitigate such risk is by hedging.
Hedging attempts to manage foreign currency risks; the risk to earnings or capital arising from movement of foreign exchange rates to avoid situations that could put a firm’s survival in jeopardy.
How it works “Hedging gives the customer certainty and ability to make good business projections and proper planning without worrying about fluctuation in market exchange rates,” said Charles Katongole of Standard Chartered Bank Uganda.
By hedging, the bank and customer agree an exchange rate that will be used to convert one currency to another at a future date.
On the maturity date, Katongole explained, both parties will exchange the given currencies at the agreed rate, regardless of current market rates at no cost.
If hedging is well executed, the firm’s financial, strategic and operational benefits can go beyond merely avoiding financial distress by opening up options to preserve and create value.
This is because it helps mitigate forex volatility risks, certainty in business projections and the firm is able to make accurate cost calculation as well as gives an edge over the competitors who leave everything to probability.
“As businesses grow and survive, it is critical for them to handle numerous changes within the environment,” Katongole explained.
“To that end where owners cannot limit such unforeseeable changes, hedging is the answer. Note that a hedge is different from speculation. Hedge should cover an underlying requirement,” he said.
There is hedging for foreign exchange, interest rates and commodity. Interest rates hedging relates to mitigating interest rates risk, say for a customer who intends to borrow from the bank.
If the customer is going to pay a floating rate, then they are definitely exposed to rises in interest rates and therefore would benefit from interest rates hedging unless they will pass on the extra cost arising from rising rates to their clients.
Effects of poor hedging When hedging is poorly executed, it can destroy more value than was originally at risk.
Before a business considers to hedge it needs to keep in mid the net economic exposure which includes indirect risks, which in some cases account for the bulk of the firm’s total risk exposure. Direct costs account for only a fraction of the total cost of hedging.
If a business is big, secure and profitable enough to handle any market volatility there is no point in starting to hedge.
To begin hedging means that you incur costs, which could be avoidable if the firm does not hedge.
“There is some initial credit analysis and scoring that we do for the customer and basing on that and our relationship a decision is made to whether we have to take any deposit in most cases will not take a deposit,” said Katongole.
“Once agreed by both parties, the forward rate cannot be changed. It is a contract,” he said.
This means the business that is hedging will lose at a time of maturity of the prevailing market rate.
Furthermore, without careful management, it can be disastrous.
Therefore, small and medium enterprises should hedge only exposures that pose a material risk to their financial health or threaten their strategic plans.
An effective risk-management programme often includes a combination of financial hedges and non-financial levers to alleviate risks.
The cost of hedging should not exceed the benefits.
