The term “derivatives” can strike fear into even the most seasoned finance executives in Ghanaian corporate establishments. This unease stems from similar hedging contracts that went awry in the gold mining industry during the early 1990s. However, the practicality of these instruments can no longer be overlooked, especially given the highly volatile market movements we have witnessed globally and, more pertinently, in Ghana.
These hedging instruments, often referred to as risk management products, are used by many corporate clients to mitigate market risk exposures. Market risks can take on different forms, such as higher interest rates leading to increased borrowing costs or sudden shifts in commodity prices that can have devastating consequences for businesses going through extreme price fluctuations.
In Ghana, the foreign exchange market has experienced increased volatility, leading to a growing concern among Ghanaian businesses about foreign exchange risks.
The primary goal of this article is first to clarify how foreign exchange risk arises. Second, it will examine risk management solutions and emphasise the importance of employing these tools to safeguard corporate entity earnings. Last, it will consider the advantages and any associated costs of these products.
The essence of this piece is not to provide a blueprint for hedging, but to underscore the disadvantages of neglecting market turbulence and the potential impact on a business. Often, businesses prefer to weather the storm, hoping for market calm. However, financial markets are rarely tranquil. In fact, periods of apparent calm often foreshadow significant turbulence.
Consider the year 2022, when the local currency depreciated by approximately 40% compared to the previous year’s marginal depreciation. This unexpected rollercoaster ride imposed a significant burden on businesses, leaving an indelible mark on history.
Hopefully, this article will serve as a foundation for discussions with banks like Absa, encouraging clients to take proactive steps to ‘insure’ their businesses against market volatility. Remember, like any insurance package, the aim is to provide protection during unprecedented market movements, which past trends indicate are probable.
How Does Foreign Exchange Risk Emerge?
Imagine a business owner in Ghana who imports and distributes electronic hardware, starting with a capital of GHS 120,000. At a hypothetical exchange rate of USD 1 to GHS 10, the business owner has spent USD 12,000 on hardware for the first cycle of imports. Assuming one hardware item (e.g., a radio) costs on average USD 100 (GHS 1000), the business owner can effectively bring in 120 pieces of radios. If he sells all the radios in the next three months and each radio in Ghana sells for GHS 1500, all things being equal and holding out on any other cost assumptions, the business owner makes a profit of GHS 60,000 (which is the GHS 500 profit multiplied by 120 units) and this translates into USD 50 profit for each radio sold. In summary, the client will make USD 6000 profit plus his initial capital of USD 12,000, bringing the total capital to USD 18,000, all things being equal. Should the business owner initiate a second round of radio imports, presuming the price per radio remains at USD 100 at the prevailing exchange rate of USD 1 to GHS 10, they would now be able to import 180 radios instead of the previous 120. Business is booming for this client on all fronts.