Mitigating the Effects of Foreign Exchange Rate Risk on Business Transactions with the Use of Financial Derivatives

by | Feb 20, 2015 | Newsletters

1.      INTRODUCTION 

In November 2014, in the midst of falling crude oil prices, the Central Bank of Nigeria (CBN) devalued the naira from N155 per US dollar to N168.[1] Since then the interbank rate at which banks trade has fluctuated between N188 to N206 per dollar.[2] In February 2015, the CBN halted its bi-weekly sale of foreign currency through the Retail Dutch Auction System (RDAS) and Wholesale Dutch Auction System (WDAS) and began selling limited amounts of dollars at an average rate of N198 per dollar to avoid having widely disparate exchange rates in the market and preserve the country’s foreign exchange reserves.[3] The CBN directed that henceforth all demand for foreign exchange should be obtained from the interbank foreign exchange market.[4] The looming forecast is that the CBN may be compelled to further devalue the naira in light of the continued decline of oil prices.[5]
The steady devaluation of the naira raises critical issues of currency fluctuations and the risk it poses on businesses engaged in transactions involving foreign currencies. This article will discuss the effect of foreign exchange rate risk on such business transactions and methods of mitigating such risk with the use of financial derivative products approved by the CBN.
2.      EFFECT OF FOREIGN EXCHANGE RATE RISK ON BUSINESS TRANSACTIONS
Foreign exchange rate risk is a financial risk that exists when a financial transaction is denominated in a currency other than the base currency (domestic or local) of a party in which revenues will be earned or payments made. The predominant risk is, where there is an adverse movement in the exchange rate of the foreign currency in relation to the base currency, this can cause a decline in value of a party’s asset, liability, portfolio or legal entity. [6]
Businesses that regularly transact in and convert multiple currencies to meet contractual obligations are particularly vulnerable to this risk and can suffer significant financial losses as a result. Recent examples include Dangote Flour Mills Plc. and Honeywell Flour Mills Plc. who recorded losses of N1.290 billion and N903 million respectively in quarters ending December 31, 2014 due to increased expenses to meet their contractual obligations in foreign currencies for imported raw materials used to manufacture their products.[7] Likewise, Nigerian seaport terminal operators have experienced 58% reduction in profits due to the fluctuations in the naira. Most of their contractual obligations are in dollars while the income received from terminal handling charges is in naira. With the devaluation of the naira, the terminal operators have had to spend more naira in order to fulfill their contractual obligations in dollars.[8]
3.      MITIGATING FOREIGN EXCHANGE RATE RISKS WITH CENTRAL BANK APPROVED FINANCIAL DERRIVATIVES
 
To mitigate foreign exchange rate risks, businesses can consider purchasing suitable financial derivatives. A derivative is a contract that derives its value from the performance or price movements of an underlying asset.[9] Such underlying assets include foreign exchange rates and interest rates. Derivative contracts are used to hedge or insure against the risk of adverse changes to the value of an asset, increase leverage or speculate on an asset.[10]  The four principal classes of derivatives are forwards, futures, options and swaps.[11]
The use of foreign exchange (FX) derivatives in Nigeria is not yet as prevalent as in other developed countries, but is steadily gaining traction.[12] Studies indicate that many Nigerian companies that could benefit from FX derivatives do not take advantage because of insufficient knowledge about these instruments.[13] Such studies have discovered that other factors inhibiting the development of derivatives markets in Nigeria include limited supply in the local market and difficulty in evaluating derivatives instruments.[14]
To stimulate FX derivatives in the Nigerian financial market, in March 2011, the CBN issued Guidelines listing approved FX derivative products that Authorised Dealers (Nigerian banks) can offer to their customers, namely[15]:
i)       Forwards
ii)     FX Options (European-Styled Call and Put Options)
iii)   FX (Currency) Swaps

iv)   Cross-Currency Interest Rate Swaps (CCIRS)

i)       FORWARD CONTRACTS

The forward contract is an agreement to convert a currency at a pre-determined exchange rate on a specified future date.[16] Companies typically purchase this hedging instrument from banks at a fee for the pre-determined exchange rate. [17]
To illustrate the impact derivatives can have, consider a hypothetical case study of a service contract (Service Contract) between a Nigerian oil company (Nigerian Customer) and a foreign engineering company (Foreign Service Provider) to provide oil drilling technical services for the Nigerian Customer’s oil rig with the contract service fee set at $3million. If between the date of executing the contract and the date of payment, the naira was devalued from N155 to N199 per dollar, the Nigerian Customer will expend N132 million more than anticipated, a 28% increase, to meet the contract price in dollars. Conversely, consider that the contract service fee was set in naira at N465 million (equivalent to $3 million with an exchange rate of N155 per dollar). Upon devaluation to N199 per dollar, the Foreign Service Provider would only receive about $2.3 million after converting the naira service fee to dollars, thus suffering a loss of $700,000 or 23% decrease in profits. In these situations, neither party secured suitable FX derivatives to mitigate their risks.
However, consider that the Nigerian Customer purchased a forward contract from a bank in anticipation of the Service Contract, whereby at the end of a specified period (e.g. 1 year), regardless of currency fluctuations, the Nigerian Customer would receive an agreed fixed exchange rate (e.g. N160 per dollar).  Instead of expending N594 million at the CBN rate of N199 per dollar to fulfill the $3 million service fee, the Nigerian Customer would only convert N480 million. Likewise, if the Foreign Service Provider had purchased a forward contract at an agreed rate of N160 per dollar, instead of receiving $2.3 million at the CBN rate of N199 per dollar, the Foreign Service Provider would receive $2.9 million when converting its service fee.
 
ii)    FX OPTION CONTRACTS
An FX option is a contract which gives a party the right, but not the obligation, to buy (call option) or sell (put option) currencies at an agreed exchange rate on a specified future date.[18] The key difference between options and forwards is that options allow a party the right, but not the obligation to act. If a party elects not to exercise this right, the contract expires without any further obligation and the party simply forfeits the sum spent to purchase the option; while with the forward contract, the party remains obligated to buy or sell the agreed currencies from the bank by the agreed date. The option contract provides flexibility against unfavorable fluctuations and potential gains during favorable fluctuations.
Relating option contracts to the case study, either the Foreign Service Provider or the Nigerian Customer could purchase an option contract for a fixed exchange rate. If the CBN or interbank exchange rate fluctuates to a rate considered more favorable than the option rate, the parties can choose to forfeit the option at no extra cost.
iii)   CURRENCY SWAP CONTRACTS
 
A currency swap is a financial instrument purchased from a bank which allows parties to swap specified amounts of loans obtained in different currencies.[19] Currency swaps can be used to obtain amounts in a particular currency without having to purchase it in the foreign exchange market.[20] Currency swaps are often utilized by companies to secure cheaper debt and hedge against exchange rate fluctuations. Countries also use currency swaps to defend against financial turmoil by allowing a country facing a liquidity crisis to borrow from other countries with its own currency.[21]
Companies do not need to secure the counter party to swap with as the banks typically facilitate the sourcing of companies with corresponding needs to carry out the swap. After the currencies have been swapped, the parties would be required to make the interest payments on the swapped loans for an agreed period.[22] At the end of the agreed period, the parties would re-exchange the principal amounts initially swapped. The re-exchanged principal amounts would be used to pay off the respective loans.[23]

To illustrate a currency swap, consider in the case study that the Foreign Service Provider under the Service Contract is an American company that wants to raise cash in naira to finance its operations at the Nigerian oil rig while waiting to receive the service fee set in naira. The Foreign Service Provider obtains a loan from its domestic US bank for the purpose of financing its operations; but rather than converting its dollar loan to naira the Foreign Service Provider purchases a currency swap from a Nigerian bank. The Nigerian Bank then connects the Foreign Service Provider with another company, which has taken out a comparable naira loan and is seeking access to dollars. With the bank facilitating the swap, the Foreign Service Provider makes the agreed interest payments in naira on the naira loan, while the other company makes the interest payments in dollars on the dollar loan. At the end of the agreed period, which is the maturity period of the loans, the principal amounts are re-exchanged and the debts of both parties will be paid off. The Foreign Service Provider will have obtained the naira currency needed via the swapped naira and dollar loans without any exposure to foreign exchange rate risk.

iv)   CROSS-CURRENCY INTEREST RATE SWAPS (CCIRS)
 
This is a type of currency swap, in which two parties exchange interest payments on their loans in two different currencies for a specified length of time.[24] Companies can purchase a CCIRS as a financial derivative product from Nigerian banks.
A CCIRS is beneficial to a borrower who has a loan in one currency (e.g. dollars), but receives income proceeds in another currency (e.g. naira). By engaging in a CCIRS, the borrower can ensure that the dollar interest payments are made without having to convert his naira proceeds to apply it towards the dollar interest payments.  The borrower would make interest payments in naira on a comparable naira loan, while a counter party to the swap would make the interest payments in dollars on the borrower’s dollars loan.
To illustrate the CCIRS, consider that in the case study, the Foreign Service Provider opts instead to purchase a CCIRS from a Nigerian bank. The Foreign Service Provider exchanges the interest payments on its dollar loan for interest payments on a naira loan. Without the CCIRS, the Foreign Service Provider would likely have had to convert a larger portion of its naira service fees into dollars at the CBN exchange rate of N 199 per dollar in order to make the interest payments on its dollar loan. However, an acquired CCIRS would ensure that the Foreign Service Provider can maintain interest payments on its dollar loan while avoiding foreign exchange rate risk entirely.
A potential problem with currency swaps is that both parties remain exposed to the risk of loan default as failure of one party to make interest payments does not excuse the other party from its original obligations.
v)     GUIDELINES FOR CBN- APPROVED FOREIGN EXCHANGE DERIVATIVE PRODUCTS
 
The CBN provides guidelines for foreign exchange derivative products, some of which include the following:
·         The maximum tenor allowed for FX Forward Contracts and by implication FX Swaps and CCIRS is five years, but Authorised Dealers can seek specific approval from the CBN for longer tenors.[25]
·         All hedge transactions must be backed by trade (visible and invisible) transactions[26]that is, there must be documentary evidence that the customer has entered into a trade transaction before offering the customer derivative products.[27]
·         To promote competitive prices of derivative products, customers are allowed to obtain derivative products from the Authorized Dealer that offers them the best prices/rates.[28]
4.      CONCLUSION
In light of the currency fluctuations facing the Nigerian market, companies engaged in commercial transactions in which either their payments and/or revenues have to be in foreign currencies, should consider mitigating the exchange rate risk on their financial investments by developing a risk mitigation strategy that utilizes FX derivative products that best suit the company’s interests. In general, companies in looking at their derivative product options should also consider whether such products would be cost effective for their transactions.

 

[1] CBN Communique No. 98 of the Monetary Policy Committee Mtg. of Monday 24th and Tuesday 25th November, 2014, p. 21 http://www.cenbank.org/Out/2014/MPD/Central%20Bank%20of%20Nigeria%20Communique%20No%20%2098%20November%202014.doc%20(With%20Personal%20Statements).pdf
[11] The Handbook of International Finance Terms by Peter Moles and Nicholas Terry
[19] The Handbook of International Financial Terms – see definition of cross-currency swap
[20] The Handbook of International Financial Terms – see definition of cross-currency swap
[21] Financial Management Study Manual – ICAEW (second ed.) Institute of Chartered Accountants in England and Wales (Milton Keyes). 2008 [2007]. Pp462-3, ISBN 978-1-84152-569-3
[25] http://www.cenbank.org/OUT/2011/CIRCULARS/FMD/GUIDELINES%20FOR%20FOREIGN%20EXCHANGE%20DERIVATIVES%20IN%20THE%20NIGERIAN%20FINANCIAL%20MARKETS.PDF
[26]Visible trade involves transfer of tangible goods, while invisible trade involves the transfer of intangible goods and/or services, including customer service, copyrights and patents.