RISK MANAGEMENT | 04 JUNE 2021

How to Hedge Your Agri/FX Risk

Absa-CIB-Author

Owen Schultz

Senior Trader: Forex Sales, Absa CIB

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In a commodity-heavy industry like agriculture, what’s the best way to reduce the foreign exchange (FX) risk?

The exchange rate is a tricky thing for an economy like South Africa’s. A strong rand means it’s cheaper to import raw materials, but a weaker local currency makes our products more competitive in the global export market. The country’s importers and exporters have to strike a delicate balance, and it’s further complicated by the relationship between commodity prices and FX rates.

“You can see that relationship in minerals like gold, platinum and palladium,” says Owen Schultz, Senior Trader: Forex Sales, Absa CIB. “But it’s also true in agriculture. A large percentage of our agricultural products are exported offshore to destinations like the United States, Europe and the Far East. On the back of that, foreign exchange has a huge impact on the South African agricultural market.”

Impacts of seasonality

That was evident in 2020, when the rand blew out to historical levels of R19 to the US dollar. “Many of the fruit exporters we deal with in the Western Cape hedged their export proceeds at those levels,” says Schultz. “Because they had budgeted at R14 or R15 to the dollar, that meant they were able to show better balance sheet numbers at the end of the period.”

And while the rand’s exchange rate is seasonal, so too are apples, grapes, pears, blueberries and so on. “Those commodities are harvested at different times of the year, so our agricultural clients will hedge their FX exposure according to that timing,” Schultz says. “If the citrus farmers are picking their citrus fruits today and shipping them in the next couple of weeks, the hedges they have in place now would have been taken out six to eight months ago.”

He recommends a staggered approach. “If you’re nine to 12 months out, you might cover about 20% of your perceived exposure. Then at nine to six months out you might push that up to 50%, and as you get closer to the harvest you’d take it to a maximum of about 80%,” he explains. “With the help of our research and technical analysis teams, we’ll tell our clients what Absa’s thoughts are, and they’ll base their hedging strategy on that.”

Future-proofed FX risk

All farmers base their business plans on forecasts of their future crop yields (larger farmers plan about five years in advance), but none can see the future.

“They’ll have an idea of what they might produce, but they don’t know if there will be a drought or hail damage during the season,” says Schultz. “As they get closer to harvest time they’ll have a clearer idea of the final quantity that will be harvested. That’s why we recommend that staggered approach.”

“Hedging requires a clearly defined policy and is a tool that can be used to transfer FX risk, commodity price risk, interest rate risk and inflation risk from business operations,” says Shanil Bisram, Senior Specialist: Multi Asset Investment and Trading Solutions. “For businesses producing commodities, the hedging strategy will depend on company-specific objectives, desired risk profile and the impact of movement in commodity prices and currency rates compared to targeted levels. As certain commodities are priced in a different currency from the local currency in which they are produced or used, there may be a relationship between the movement in the local currency and commodity currency pair when compared to the movement in the price of the underlying commodity. The implications of the relationship identified, whether positive or negative, ought to be evaluated in determining an optimal hedging strategy for the business.”

Businesses that have exposure on commodities priced in foreign currency or are price-linked to an international commodity benchmark can benefit from having a well-crafted hedging policy that addresses mitigation of FX risk and commodity price risk, as this in turn can provide certainty on prices for projected sales. Agricultural businesses have uncertainties such as crop yields to consider. In this case, a staggered hedge approach structured with a portfolio of hedge instruments (including option strategies which allow for a level of participation) can benefit the price achieved for projected sales – especially in volatile markets. For businesses that have input costs that are price-linked to an international commodity such as diesel, proxy hedges which are highly correlated to liquid benchmarks may assist in providing certainty in costs.

A well formulated policy with a supportive execution strategy can be effective in reducing market risk exposure for a business.

Getting the risk balance right

Balancing that right-way/wrong-way risk also helps exporters to avoid over-hedging on their FX hedges. “When the harbours and airports were partially closed during 2020’s hard lockdown, agriproducers that were trying to export their product would have had delays with the flow of foreign funds due to delay of the product arriving at the final destination,” says Schultz. “However, if they had taken the staggered approach they would have been okay because they weren’t over-hedged.”

Farmers already have to contend with risks such as unfavourable weather conditions, crop-destroying pests, unstable fuel prices and tricky export markets. The last thing they want is to add FX volatility to that list. Managing their FX through a careful, research-backed hedging approach won’t guarantee a bountiful harvest, but it will at least lighten their basket of risks.

Absa-CIB-Author
Owen Schultz

Senior Trader: Forex Sales, Absa CIB

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