Why a Favourable Exchange Rate Should Strengthen Your Treasury Strategy, Not Replace It

One of the more difficult aspects of currency risk management is that businesses often become less disciplined when exchange rates move in their favour.

When exchange rates are uncomfortable, currency risk becomes highly visible. Import costs increase, export margins come under pressure, budget assumptions are challenged and management naturally starts asking questions about hedge cover and future exposures.

When the market moves favourably, however, the opposite can happen. The urgency disappears.

An importer may decide to wait because the rand could strengthen further. An exporter may suddenly increase hedge cover because the stronger rand has made future receipts less attractive. Decisions that were previously governed by policy, margins and exposure certainty can quickly become influenced by expectations of where the exchange rate may move next.

A favourable exchange rate can therefore create one of the biggest behavioural risks in treasury: the temptation to replace risk management with market timing.

The problem is not having a market view. Treasury teams will naturally consider market conditions when making decisions. The problem begins when that view becomes the primary reason for leaving a material commercial exposure unmanaged.

A Good Exchange Rate Does Not Mean the Risk Has Disappeared

Consider a company importing goods from an offshore supplier. When the purchase is approved, assume the business calculates that the transaction remains commercially attractive at a USD/ZAR exchange rate of 16.50. Pricing, expected margins and working capital requirements are therefore built around this assumption.

If USD/ZAR subsequently moves to 16.00, the economics of that transaction have improved materially. For every USD1 million payable, the company’s expected rand cost is approximately R500,000 lower than it would have been at 16.50.

This is clearly positive. But the foreign currency liability has not disappeared.

The supplier still needs to be paid. The settlement date still exists. The business still has a USD exposure and remains vulnerable to any unfavourable movement between the present day and the date of payment.

The important treasury question is therefore not simply: Can the rand strengthen further?

A more useful question is: How much of this improved commercial position should the business now protect?

The distinction is important. If the transaction achieved the required margin at 16.50 in terms of USD/ZAR, an exchange rate of 16.00 may provide an opportunity to secure an outcome that is already better than the original commercial assumption.

Choosing not to protect any of that improvement is also a decision. In effect, the business is deciding that the possibility of a better exchange rate is worth the risk of losing the favourable position already available.

That may be an acceptable decision within an approved treasury framework. But it should be recognised for what it is.

When Treasury Decisions Become Market Predictions

Treasury decisions can gradually change as markets move. An importer might initially determine that 16.50 provides sufficient certainty over costs. When the rand strengthens to 16.30, management may decide to wait for 16.20.

At 16.20, the target thereafter may move again to 16.00. If 16.00 arrives, expectations may shift towards 15.85.

There is always another potentially better rate. The difficulty is that the company’s underlying obligation has not changed during this process. The exposure remains. What has changed is the organisation’s expectation of what the currency will do next, versus the original position at 16.50 at the start.

This is where a legitimate treasury decision can quietly become speculation.

The purpose of treasury management is not to determine the strongest or weakest point of a currency. It is to understand what exchange rate outcomes the business can tolerate and then manage exposures accordingly.

No treasury team can consistently identify the best exchange rate available over the life of every transaction. Nor should that be the standard against which treasury performance is measured. The objective should be to create acceptable and repeatable financial outcomes.

Importers and Exporters Face the Same Behavioural Problem

Importers and exporters experience favourable and unfavourable exchange rate movements differently, but the behavioural risk is remarkably similar.

When the rand strengthens, an importer benefits from lower expected foreign currency costs. As the rate becomes increasingly attractive, the importer may become progressively less willing to hedge. Why lock in today’s rate if tomorrow’s may possibly be better?

The business can then find itself with a significant open position simply because recent market movements have been favourable.

If the currency subsequently reverses, behaviour often changes very quickly. The business that was reluctant to hedge at an attractive level may suddenly feel compelled to hedge after the rate has deteriorated. The organisation has moved from confidence to urgency.

Exporters can make the opposite version of the same mistake. A stronger rand reduces the rand value of future foreign currency receipts. Management may therefore become increasingly uncomfortable as the exchange rate moves against the exporter and may respond by rapidly increasing hedge cover.

But forecast export receipts are not always certain. Production volumes can change. Customers can alter orders. Shipments can be delayed and expected payment dates can move.

Hedging too aggressively simply because the prevailing exchange rate is uncomfortable can therefore introduce another risk: the organisation may eventually become over hedged at some stage.

In both cases, the problem is not the hedge itself. The problem is allowing recent exchange rate movements to determine the organisation’s risk appetite.

Start With the Business, Not the Exchange Rate

A disciplined treasury decision should begin with the underlying commercial exposure.

Before deciding whether an exchange rate is attractive or unattractive, management should consider asking the following questions:

• What exchange rate was used when the transaction was priced?
• What exchange rate has been included in the company’s budget?
• At what rate does the transaction still achieve the required margin?
• How certain is the underlying exposure?
• What percentage of the exposure has already been hedged?
• When will the cash flow occur?
• What would a significant adverse currency movement do to the company’s cash flow or profitability?
• And what does the company’s treasury policy require?

These questions change the nature of the decision.

Instead of asking the treasury department to predict the next exchange rate movement, the organisation is determining whether the prevailing market allows it to achieve its commercial objectives at an acceptable level of risk.

The market rate should inform the decision. It should not become the decision.

This is particularly important when rates move materially in the company’s favour. A favourable market does not necessarily mean that the entire exposure should immediately be hedged.

It may instead create an opportunity to increase FEC positions progressively. A portion of a confirmed exposure could be protected while some participation in further favourable movement is retained. Highly probable or forecast exposures may be hedged at lower percentages until greater certainty develops.

The appropriate approach will depend on the nature of the business, its risk appetite and its treasury policy. What matters is that the decision is deliberate.

The Problem With Hindsight

Treasury decisions are particularly vulnerable to hindsight.

An importer who hedges a USD payment and subsequently sees the rand strengthen further may, once the payment has been completed, feel that the hedge was a mistake and that waiting longer would have resulted in a better outcome.

An exporter may have exactly the same reaction when the rand weakens after foreign currency receipts have been hedged, or converted on receipt.

With hindsight, almost every hedge can eventually be compared with a better exchange rate. But that is not a meaningful measure of whether the treasury decision was successful.

Suppose a transaction was priced at 16.50 against the USD and the business secured its required margin by hedging when the USDZAR spot rate was at 16.00. If the exchange rate later reaches 15.70, it does not automatically mean the original decision was incorrect.

The company achieved an exchange rate materially better than the rate on which its commercial assumptions were based and removed uncertainty over the future cash flow. That has value.

A hedge should therefore be evaluated against the objective it was intended to achieve, rather than against the best exchange rate that became available afterwards.

• Did the hedge protect the expected margin?;
• Did it provide greater certainty over the cash flow?;
• Was the transaction consistent with the company’s treasury policy?;
• Was the hedge percentage appropriate for the certainty of the underlying exposure?;
• Did it prevent an unacceptable financial outcome?

These are better measures of treasury performance than asking whether management could have achieved another ten or twenty cents by waiting.

A Favourable Market Creates Choices

A favourable exchange-rate movement should not simply be viewed as an opportunity to obtain a better rate. More importantly, it creates strategic choices for the business.

An importer may have an opportunity to protect lower purchasing costs or increase hedge cover without compromising its original budget assumptions. An exporter may be able to reassess hedge ratios and protect required margins in a measured way. In both cases, favourable market conditions can also provide greater certainty over future cash flows and working capital requirements.

Importantly, this does not mean that the entire exposure should automatically be hedged. Depending on the certainty of the underlying exposure, the business may choose to layer hedge cover progressively while retaining appropriate flexibility over the remaining position.

This is fundamentally different from leaving an entire exposure open simply because management expects the market to continue moving in its favour.

One represents a deliberate treasury decision within an agreed framework. The other represents a currency view.

Favourable Markets Are Where a Robust FX Policy Proves Its Value

This is where a well-structured FX policy becomes particularly important.

A robust policy establishes, in advance, how the business intends to manage its currency exposures. It should provide guidance around hedge ratios, time horizons, forecast certainty, decision-making authority and the commercial outcomes the organisation is seeking to protect.

When these parameters have already been agreed, management does not need to redefine its risk appetite every time the exchange rate moves.

Instead, the policy is allowed to play out as intended.

If an exchange-rate movement creates an opportunity to protect a margin that meets or exceeds the company’s commercial objective, the policy provides the framework for acting on that opportunity in a measured and consistent manner. Similarly, where only a portion of an exposure should be protected, the policy allows the business to retain appropriate flexibility without unnecessarily exposing the entire position.

This is one of the key benefits of having a robust FX policy: it replaces reactive decision-making with predetermined parameters that are aligned with the underlying needs of the business.

It also helps remove much of the emotion associated with currency movements. Management is less likely to continuously move target rates, delay decisions in pursuit of a better level or materially change hedge cover simply because the latest market movement has altered sentiment.

The value of an FX policy is therefore not only evident when markets move against the business. It is equally valuable when markets move in its favour.

A well-implemented policy allows favourable exchange-rate movements to be converted into tangible benefits for the business and its clients, while maintaining consistency through different market cycles.

From a Good Exchange Rate to a Good Business Outcome

Effective treasury management is ultimately not about achieving the best exchange rate in hindsight. It is about achieving acceptable commercial outcomes consistently.

A good exchange rate is valuable when it can be translated into something tangible: a protected margin, greater certainty over a future payment or receipt, improved working capital visibility or a more predictable financial outcome.

This is why the starting point should always remain the underlying business exposure.

What rate does the business require? How much of the exposure is certain? How much risk is the organisation willing to carry? How much of the favourable outcome should now be protected?

These are treasury questions. Where the exchange rate will trade tomorrow is a market question. The distinction matters.

Businesses cannot control currency markets, but they can control the framework through which they respond to them. A strong treasury policy does not prevent a company from benefiting from favourable exchange-rate movements. Rather, it provides the discipline required to participate in those movements without placing an already acceptable commercial outcome unnecessarily at risk.

Ultimately, this is what a successful treasury strategy should achieve: consistency in decision-making, protection of commercial margins and greater certainty over future cash flows, irrespective of whether the prevailing market feels favourable or unfavourable.

A good exchange rate is an opportunity. It should never become the company’s risk management strategy.

If favourable currency movements have materially changed the economics of your foreign currency exposures, it may be an appropriate time to reassess whether your hedge cover, budget rates and treasury policy remain aligned.

Connect with us for a discussion on whether your current treasury strategy is converting favourable market conditions into greater certainty for your business.