Hedging the Shilling

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It is quite astonishing to note that very few corporations in Uganda, public or private have put in place mechanisms to hedge against fluctuations in foreign exchange. It is also quite astonishing to note that since about five years ago Ugandans have been actively trading (or investing through the traders) foreign currency on the internet through broker-dealer sites such www.etoro.com or www.forex.com but have never grasped the concept of hedging.

Hedging is simply the putting in place mechanisms that limit one’s exposure to a risk that is likely to occur and which would in turn lead to a loss in money. In terms of monetary hedging, it falls mainly in trying to mitigate risk of either falling local currency against foreign currency in which one expects to settle a debt/liability or appreciation of the local currency against a foreign currency in which one expects payment.

If we are to look at both scenarios there is a loss of income through the movement of the exchange rate. In the first instance for example suppose a payment of USD 1million is due for payment in 3 months and at the time the dollar is trading at Ushs 2,000. This would mean if you were to pay now only 2billion shillings would be spent, but in the event that the shilling depreciates to Ushs 2,500 per dollar then you would have to look for an extra 500million shillings in the three months.

And in the second instance if suppose a receipt of 1million dollars was expected and the spot rate for the dollar was 2000shs then 2billion would be expected. However in the unfortunate bit that the shilling appreciated against the dollar and traded at 1,500shillings then a loss of 500million shillings would have been incurred.

Hedging therefore is a tool used in financial markets to mitigate such risks. Before the advent of the computer and special algorithms, hedging was a very simple tool which in fact is said to first have been attributed to a tale a Greek philosopher Aristotle said of fellow Greek philosopher Thales of Miletus. Thales is said to have rented out all the olive presses in Miletus predicting that there would be a good harvest of olives. The olive press owners/operators welcomed this and rented him the rights to the presses in the time of harvest exclusively. As such when the good harvest occurred he alone had the rights to the olive presses and thus made a lot of money by leasing out their use to the farmers to produce olive oil. This is said to be the first application of a hedge or in particular a call option i.e. an option but not an obligation to buy something.

Ugandans have not been able to use this predictive financial modeling to limit risks or even increase their wealth like Thales did in 600B.C. But is it out of our grasp. Actually many financial institutions have these packages and most use them in their own foreign currency transactions to hedge themselves. Many multinational companies also utilize some sort of hedging tool mainly around monetary hedges where say if company A incorporated in Uganda and has to purchase goods in Kenya where Company B a related company to A is incorporated, company B will do all the purchasing and vice versa. Thus the multinational since owned by one person/same shareholders is never bothered by the intercompany debts/liabilities as long as they are well reconciled. This in essence avoids the Ugandan company from worrying of buying Kenya shillings since all transactions in Kenyan shillings shall be settled by Company B and likewise all Uganda shillings will be settled by Company A.

Every time we note a spike in the forex market of the dollar against the shilling we expect a sharp increase in our essential commodities like petroleum. But the oil companies purchase large volumes of oil probably in terms of oil tankers and this requires a lot of US dollars which is the market currency for the petroleum on the world market. The companies however earn their revenue in shillings and thus the appreciation of the dollar is always an unwelcome event as it will almost always require the use of more shillings to buy the petroleum. It thus becomes imperative for this oil importing company to mitigate its exposure to this foreign currency risk by hedging itself against the appreciation of the dollar on the shilling. Since the power of currencies is almost relative to the purchasing power and inflation in the corresponding currency economies then it is almost always certain that the shilling shall be lower in value than the US dollar since our population has less purchasing power (number of items/services that can be purchased in a unit of currency – i.e. one shilling and one dollar) and our inflation is way higher than the USA’s. This shall stand as a basis upon which a prediction of future exchange rates and the oil importing company can use to hedge itself.

Hedging however has over time been misinterpreted to mean speculation. It should be noted that hedging involves a lot of financial and economic analysis whereas speculation is merely done on whim and thus most money put in the purchase of equity, debt or assets cannot be entirely classified as investment since most is placed without due analysis of the underlying factors that would ideally influence future earnings such as change of consumer tastes, economic conditions and so on.

The financial industry in Uganda though it grew at a remarkable 10.3% n 2010/2011 most of it was registered growth of branching out to other streets in the same city barely increasing their customer base but rather decreasing congestion at the tills in order to process more transactions. The industry needs to look at these spikes in the shillings value as an opportunity for them to introduce to their corporate and big retail clients the concept of hedging which will not only save money for their clients and make the more money for themselves in these transactions but also enable the stabilization of the shilling against the other currencies.

1 COMMENT

  1. So will Ugandan banks start selling currency options for UGX? Seems highly unlikely given the trend of the shilling against strong currencies only ever seems to be downwards!

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