foreign exchange risk management – understanding its significance to your business

by David Irish | September 1, 2021

If you haven’t analysed your business’ sensitivity to fluctuating exchange rates and developed a comprehensive risk management policy, that you then consistently apply, you are essentially driving through a snowstorm without snow tyres to protect you from the ice patches ahead.

A few years back an exporter faced the scenario illustrated below; maybe you did too.

  • From January through to December 2017 the rand strengthened steadily.
  • But then it suddenly weakened by 16% against the Euro in 3 months.
  • The business didn’t have a foreign exchange policy in place and simply converted its receipts at spot and occasionally took out forward cover when the CFO thought the time was right.
  • Over this period, there was minimal forward cover in place, cash flow was tight and borrowing facilities were at their limit.
  • It was the perfect storm.

So, what happened?

  • From August through to November was the summer selling season priced at an average exchange rate of R16.04 to the Euro.
  • A significant foreign customer got into financial difficulties and had to delay payment which led to receipts coming in at an average rate of R15.02; a loss of R1.23 to the Euro.
  • With significant input costs having to be paid in December and January, the company’s cash flow got caught in a vice grip and they had to be bailed out.
The rand is one of the most volatile currencies in the world. This chart reflects the 30-day volatility of the rand against the dollar and then the Euro against the Dollar.
What this illustrates is that since 2016 the Rand has been more than twice as volatile as the Euro was against the Dollar on an annual average basis.

This is quite a rocky road for a business to navigate without a proper plan in place.

So how do you put a plan in place?

First, you need to analyse each foreign currency cash operating cycle. Most businesses will have several due to different products, seasonality, sourcing supply chain lead times and terms, and customer locations and terms, for example.

The results of this analysis will determine how your exposures can be distilled into distinct risk profiles for which a policy can be formulated.
Formulating a policy involves identifying and quantifying several key parameters, including:

  1. The reference rate of exchange
    This is the exchange rate you use to calculate the selling price of the goods or services you will export or import.
  2. The time horizon
    This is the period during which the business does not change its reference rate and will depend on the specific product or services’ market dynamics. This might be annually, seasonally, whenever there’s a price list update, or at the time of each quotation.
  3. The exposure period
    This is the period for which a specific transaction will be affected by exchange rate fluctuations.
  4. The foreign exchange position
    This is the measurement of all foreign currency exposures, transactions, and balances at a single point in time. Ideally It should include off balance sheet confirmed exposures such as sales orders or purchase orders but may also include unconfirmed exposures such as forecasts. This enables you to evaluate the total risk from which you can do an assessment of the sensitivity of the position on a high-level basis to % changes in the exchange rate.
  5. The hedging strategy
    There is a myriad of hedging strategies to choose from. It is very important that the strategy you choose fits the business. Factors to consider would include:

• the risk appetite of the shareholders and executive,
• whether the board and the executive understand the strategy, and especially the hedging instruments involved, and
• the skills and experience of the finance team to effectively apply the strategy

Throughout the process and most certainly before a draft is finalised it is absolutely critical that you TEST, TEST, and TEST the probable effectiveness of the policy. There are several ways of doing this depending on the skills and tools available to you.

The chart below demonstrates what a carefully planned and structured foreign exchange policy can do for a business. In this example we are looking at an export business, where the exposure period is 49 days on average and the reference rate for pricing purposes is determined on a weekly basis.

The green line indicates the market rates at the time of sale, while the red line depicts the gain or loss relative to the reference or costing rate using the spot rate at receipt of funds. You can clearly see the volatility and the timing differences that arise from not managing the risk and simply converting from Dollar to Rands when the funds are received.

The blue line depicts the result of applying a well-constructed and tested policy on a consistent basis. Note that because the reference rate used for pricing in this example is only updated once a week, there is still some volatility associated with the policy.

In this example, applying the unmanaged approach, resulted in 128 loss days exceeding 20 cents over the 7 years, with a significant number exceeding R1 to the dollar and a maximum loss of R2.32. In contrast the managed policy result achieved a consistent annual gain exceeding 10 cents to the dollar, and only incurred a loss greater than 20 cents 8 times, with a maximum daily loss of 65 cents – thus protecting the bottom line and cash flows but still offering some upside opportunities.

The often-misunderstood forward points

Forward points is the term used for the difference between the spot exchange rate and the forward rate of exchange at the same point in time.

I have often found that many business owners and even financial accountants do not fully understand what forward points are and how they are calculated. Essentially, forward points reflect the difference in interest rates between one country and another. In order to understand how this differential determines the forward exchange rate let’s follow the process that was originally followed by banks in order to offer their clients a fixed rate of exchange at some point in the future.

The diagram and explanation below provide an example of an export forward exchange rate determination.

We start with a Wauko client and its South African bank on the one side and Wauko’s client’s customer and their bank in the US.

  1. On day one the client ships a product to its US customer for one dollar. The customer will only pay in one year’s time. Our client does not want to be exposed to currency risk and so approaches its bank to fix the rate.
  2. In order to secure that one dollar’s conversion in one year’s time the bank will immediately borrow one dollar for one year at a rate of 4.75%, the interbank borrowing rate in the US.
  3. It will then immediately convert those dollars to rand at today’s spot rate. In this example we use R10.00/USD for ease of reference, and
  4. invest it at a South African interbank money market interest rate of 10% for one year. So now you can see that there’s a 5.25% interest differential between US and South African interest rates. This a key number.
  5. At the end of the year the US customer pays the one dollar which the bank then uses to settle the capital on its US dollar loan.
  6. At the same time, it receives R11.00 from its South African money market investment. (R10.00 capital plus R1.00 interest). For the sake of simplicity, we assume that the spot rate is still at 10 so from the one rand earned it must pay its US dollar interest using R0.475.
  7. This leaves R0.525 cents plus the original R10.00 that must be paid to Wauko’s client. So, ignoring any bank margin or costs this enables the bank to quote Wauko’s client a one year forward rate of R10.5250. The 52.5 cents are what is termed the “forward points”

At time of writing US interbank interest rates are around 0.15% whilst SA interbank rates are around 5.05% giving an implied interest rate differential of 4.90%.

Exporters earn these forward points, but importers pay the bank these forward points because the interest rate differential is the other way around.

Many importers think that the bank is charging them this forward points “premium” so they can earn more margin but as you can see it is predominantly a function of the interest rate differential between two currencies.

A lot of exporters don’t factor in the effect of forward points. Not only do forward exchange contracts provide certainty of future cash flows, but they also add to the bottom line; approximately 4.90% per annum on Dollar transactions at the time of writing.

risk margin

Most importers and exporters refer to a “risk margin” that they apply to factor foreign exchange volatility into their costings. However, most times this margin is a “thumb suck” with no empirical support and can therefore have a significant impact on their competitiveness. Under a properly formulated risk management policy, this margin is factored in to address the time horizon risk (the risk that the exchange rate moves against you while you are unable to adjust your selling prices) as well as the forward points effect based on an empirical analysis of the policy parameters adopted.

By way of an example, we have an import client who historically costed using a R0.80 risk margin. After performing a proper analysis and policy development we determined that the client could afford to reduce the margin to R0.40. The client operates in a highly competitive industry, so you can imagine the effect this had on their ability to improve their competitiveness and increase market share.


Not taking your foreign exchange risk management seriously by developing and consistently applying a properly formulated policy can seriously affect the sustainability and growth of your business.

At worst it can sink the business and at best distract management from doing what they should be doing. So instead of lying in bed dreaming about new products, markets, or efficiency improvements they’re stressing about what global and local events might negatively affect their impending foreign currency cash flows.

Our Wauko policy development team have extensive experience in analysing both import and export foreign exchange risk across a diverse range of industries. If you need help to protect and improve your bottom line, connect with us at


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