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How investors can mitigate currency risks

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Currency risk or foreign exchange risk is one thing investors are keen to wish away considering its disastrous impact on the value of their investments.

A report titled “Top 10 risks for businesses operating in key sectors of the Nigerian economy in 2018/19” complied by KMPG, showed that currency risk had the highest weighted score of 3.91 out of 5.00, ahead of fiscal & monetary policy risk, crude oil price risk and regulatory risk.

The report which captured the opinions of 94 business leaders across Nigeria about the risk they anticipate would affect their organizations, showed that political risk, interest risk and insecurity risk weigh less on business performance and profitability than currency risk.

“Despite notable measures undertaken by the Central Bank of Nigeria, the residual effects from the devaluation of the naira continue to weigh on corporates. Hence, executives and investors are significantly concerned about foreign exchange and its impact on profitability”, the report noted.

Currency risk is the risk that changes in the relative value of certain currency will reduce the value of investments denominated in foreign currency, emanating from the change in the price of one currency in relation to another.

If not appropriately managed, currency risk presents exposures that exert adverse implications on organization’s financial performance. It is nothing special for companies with currency exposure to undervalue the financial implications of currency volatility on their business and miss the opportunity to create a formidable currency risk management strategy.

Investors or multinational organizations that have assets across national borders are exposed to this kind of risk as it creates unpredictability in business profits (or losses). When an investment or a fraction of an investment is in foreign currency, it is susceptible to risk because it is affected by any change in the value of that currency. Many businesses have cash assets in foreign currencies and if exchange rates are unstable in terms of one another, it produces risk.

Investors as well as businesses need foreign exchange to meet foreign currency-denominated input costs, service foreign currency liabilities and repatriate profits (in the case of multinational firms). On the contrary, local firms with strong international spoor might earn foreign exchange from their export receipts.

However, given the fact that the economy of the country is titled towards import-dependency, it therefore connotes that currency risk for a large chunk of Nigerian firms relates to payments, not receipts.

Last year, CBN intervention to stabilize the naira paid off as the domestic currency fluctuated against the dollar in the parallel market with close margin to open at N355/$, peak at N368.39/$ to close the year at N364.50/$.

As election draws near, anticipated pressures have filled the air as many analysts projected that the naira would depreciate against the dollar towards N390/$ this year because of political uncertainties and oil price volatility, despite the commitment of the CBN to sustain stability.

The question that comes handy is how can investors mitigate currency risk peradventure the unexpected occur.

Zeal Akaraiwe, Chief Executive Officer, Graeme Blaque Advisory, stated that currency risk can be mitigated in a number of ways and for Nigeria, with strict exchange controls, the instruments available for currency hedges are forwards, swaps and naira settled futures contracts on the FMDQ platform.

“Depending on the investors perception of the magnitude of risk, the return being expected on the portfolio/direct investment and the possible contagion on other asset classes, such investor can then decide which instruments or combination of interests will be most effective”.

In her estimation, Olohunlana Olayinka, a Lagos-based economic and financial analyst, told BusinessDay that investors could minimize the impact of losses through the option of currency hedging, a currency risk management approach.

“Investors can enter into a financial contractor through buying hedge instruments to forestall risks associated with currency volatility. The purchase would be in an alternate currency different from the investment currencies”, she said.

Speaking further “So by the time the investment matures and seek for liquidation, the currency exchange will differ from the initial or the currency of the country in which the investment is domiciled”.

Olayinka’s stance corroborated Zeal’s position that investors could use stocks, insurance options or currency swaps to manage currency risk.

In simpler terms, a hedge is a strategy intended to protect an investment or a portfolio against loss. It actually involves buying securities that move in opposite direction than the asset being protected.

“Hedging protects against unforeseen events but investors usually hope they never have to use it”, a Forex expert, who pleaded anonymity, posited.

“People insure their house because the odds of having one’s house destroyed are relatively small, this may seem like a foolish investment. But our homes are important to us and we would be devastated by their losses”, adding that

“Using options to hedge your portfolio essentially does the same thing. Should a stock or portfolio or currency taken an unforeseen turn, holding the option opposite of your position would help limit your losses”, he stated.

To Abimbola Oyetola, fixed income analyst at ECO Bank Plc, it is unlikely for the naira to depreciate largely against the dollar in 2019, although it can lost value by a single-digit, however considering the uncertainties in the global economy and risk sentiment globally, it makes sense for investors to take some protection against possible currency risk”

“Investors can prevent currency risk basically through three ways namely reducing currency mismatches, purchasing hedging instruments in the market and by diversifying portfolios”, Abimbola noted.

As regard reduction in currency mismatches, investors and businesses should ensure that the differentials in their foreign currency liabilities compared assets and revenue should be slim, implying that investors should not be short of net foreign currency.

Investors can take further protection by buying naira-settled OTC futures in the FMDQ, a product that helps investors to hedge foreign currency against risk.

Retail investors wishing to manage currency risk are advised to diversify their portfolio in foreign-denominated assets such as euro-bonds.

 

ISRAEL ODUBOLA & ADAMS SEGUN

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