Welcome to Part II of our exploration into the world of derivatives, or, as we’ve referred to them, Risk Management Products (RMPs). Having laid a foundational understanding of derivatives in Part I, where we traced their historical origins and outlined their evolution into a broad spectrum of financial instruments, we now delve deeper into the practical aspects of managing risks associated with these tools.
In this segment, we will focus specifically on identifying and mitigating the key risks that businesses face in today’s volatile market environment. These include foreign exchange risk, interest rate risk, commodity price risk, and credit risk. Each of these areas presents unique challenges and requires tailored strategies to safeguard business interests effectively.
We will also explore the mechanisms of RMPs that can be utilised to manage these risks. Our goal is to demystify the complexity surrounding these products and provide actionable insights for businesses looking to enhance their financial stability and market responsiveness.
Foreign Exchange Risk
To begin with, clients engaged in the trade of goods and services across borders are vulnerable to currency risk. How? At any given point, an importer would have to purchase foreign currency to make payments to a supplier outside their home jurisdiction. Depending on how exchange rates fluctuate in this home jurisdiction, the importer may either need more local currency or less of it to acquire a unit of foreign currency. The lack of adequate local currency to purchase a unit of foreign currency may lead to the business becoming unprofitable.
Conversely, an exporter earning foreign currency faces risks if the local currency strengthens. For example, in Ghana, exporters earn in foreign currencies but must convert these earnings into Cedis. If the Cedi appreciates, the amount received per unit of foreign currency decreases, adversely affecting profits. A sure way to avert losses or being on the wrong side of the market is to enter into a hedging solution which protects you from adverse currency movements.
Interest rate risk
Businesses may also be vulnerable to interest rate risk, particularly if they have procured debt tied to a floating rate benchmark, such as the Chicago Mercantile Exchange (CME) 3-month Term Secured Overnight Financing Rate (SOFR). As the policy rate fluctuates, so too will the repayment obligations on this debt, moving in tandem with rate changes. This variability can cause significant concerns for debtors, especially in a rising interest rate environment, which can increase their financial burden and potentially lead to breaches of loan covenants with financial institutions, risking a default.
To mitigate these risks, businesses can implement various interest rate hedging strategies designed to limit the impact of rate increases. Conversely, in a disinflationary economic climate where rate cuts are anticipated, investors might seek to protect their returns from decreasing due to lower interest rates. Employing interest rate hedges can safeguard investments from the adverse effects of falling interest rates, ensuring more stable financial outcomes.
Commodity Price risk
The volatility in commodity markets can be profound, posing significant risks for producers and consumers alike. It is crucial for these parties to mitigate the variability in future cash flows and secure some level of certainty through Risk Management Products (RMPs). These solutions apply across a diverse range of commodities, from precious metals like gold, silver, platinum, and palladium, to base metals such as copper, aluminium, zinc, tin, lead, and nickel.
Energy commodities, including crude oil, fuel oil, and gas oil, as well as agricultural products and soft commodities like coal, natural gas, and electricity, are also viable underlying to consider for hedging. The unpredictability of these markets underscores the necessity of RMPs; since future prices cannot be predicted with certainty, carpe diem – seizing the day and employing hedging strategies is essential to manage risks effectively.
Credit Risk
Credit risk arises whenever there is a lending arrangement between a lender and a borrower. This risk encompasses the possibility that the lender may not receive full or partial repayment of the loan, potentially resulting in financial losses. Often, the financial health of the borrower may not be the predominant cause of their inability to pay; some macroeconomic condition which impact the borrower’s ability to repay may exist. Nonetheless, the investor, in this case the lender, will suffer the consequences.
Recent instances, such as the government’s inability to meet its debt obligations leading to a restructuring known by the acronym DDEP, have heightened interest in credit risk. Fortunately, there are available instruments designed to hedge against the risk of borrower defaults. This is crucial because it facilitates more lending arrangements, which are needed to propel growth by guaranteeing the lender that they will be made whole by the economics of the hedging instrument. We will look at this in more detail in a subsequent writeup to this article.
Having outlined various market risks, it’s beneficial to explore the hedging instruments that address foreign exchange, interest rate, commodity price, and credit risks. The purpose of this overview is to enhance awareness and stimulate dialogue among market participants about the use and development of these instruments for a broader range of clients. In Part III of our series, we will begin with the most commonly utilised instruments, Forwards and Swaps.
Gerald is the Head of Institutional Sales and Structuring at Absa Bank Ghana and Jacob is the Head of CIB Markets at Absa Bank Ghana .
