The Naira is currently trading close to its all-time lows. In a little under a year, the Naira has fallen more than 49%. The Naira traded at N735/$ on January 1, 2023, but currently exchanges hands for about N1145/$.
Many investors have seen their wealth stored in Naira denominations erode because of this decline and in a bid to safeguard their Naira-based assets, most investors have turned to a risk management approach called hedging.
In this article, you will find out exactly how to hedge your Naira assets using dollar-denominated assets.
What is hedging?
Hedging is a wealth preservation strategy that aims to save assets from depreciation by taking an opposite investment in a related asset.
Hedging is not done to get wealth but to mitigate losses from an existing bad investment.
If a particular stock is falling rapidly and you have several units, you can decide to open a leveraged short position and profits from this short position will cover up for losses incurred from the depreciation of the stock.
Hedging is also a common strategy for currency pair speculators because instead of leaving assets denominated in a particular currency, speculators can reduce their risk by diversifying to other stronger currencies.
This simply implies that that investors can take advantage of strength in foreign economies and currencies especially that of the US Dollar.
The risk of having all your assets in a single denomination
Diversification is one of the best methods of risk mitigation in investing. The cliche statement “Do not store all your eggs in one basket” is applicable in this instance.
You do not want your financial situation to be tied to the performance of one currency or asset, as it is highly ludicrous to have to face serious portfolio losses simply because one asset underperforms.
For instance, in September 2022, the British Pound fell against the Dollar hitting lows that haven’t been seen since 1987.
Investors and business owners who had all of their assets denominated in the pound were among the worst hit.
Shai Weiss, a top executive of popular airline Virgin Atlantic in September 2022 described how his company hedged against the ailing pound.
In Nigeria, businesses with international exposure are struggling to stay afloat as they are taking the heavy economic punches as a result of the Naira’s ailing health.
According to Bloomberg, Multichoice the parent company of DSTV and GoTV have recorded a third straight month of losses following the abysmal Naira performance this year.
Smart investors and business owners do not leave anything to chance, they hedge if necessary to protect their assets.
Hedging Strategies
- Asset allocation
Asset allocation is a hedging method designed to mitigate risk and enhance portfolio diversification. Business owners and speculators may decide to allocate certain percentages of their assets to two opposing assets to mitigate risk.
For example, Uche, an electronics importer in Alaba may swap 60% of his Naira revenue to Dollar-based assets every two months to save them against depreciation.
The premise for such a strategy is the belief that in the medium to long term, the Dollar will outperform the Naira.
- Futures and options
Derivatives like options and futures are also great alternatives for hedging. Derivatives are contracts that are tethered to assets and move in tandem with their base assets.
However, derivatives can be traded in both directions. Long and short for futures contracts and the call and put for trading options.
An investor may hedge their Pound-based investments by shorting the Pound futures contract. Even if the pound plummets, profits from the short contract will mitigate the losses.
- Trading on haven assets
Haven assets are assets that have notoriety for maintaining their value even when other assets are in decline.
Haven assets like the US Dollar, Gold, Silver, and other precious metals are great for hedging purposes. Gains from their appreciation would help mitigate losses in the case of depreciation of your original investment.
Excellent Dollar Assets to hedge against the Naira depreciation
- Dollar funds
Dollar funds are investment funds valued and traded in U.S. dollars, irrespective of the investor’s native currency. For example, even though banks like Stanbic IBTC. are primarily Nigerian entities, they offer dollar-denominated funds.
The interesting thing about these dollar funds is the fact that the returns are also paid in dollars. Let’s look at this scenario to understand how significant this means.
If Ade invested $1000 in Stanbic IBTC dollar fund (it has a 5.39% YTD return), his principal plus returns would currently be at $1053.9.
However, the dollar has appreciated by roughly 49% since January. This means his initial $1000 investment would have appreciated by more than 50%.
Investing in dollar-based assets is a very reliable way of hedging against Naira volatility.
Dollar based ETFs
Exchange-traded funds ETFs should not be mistaken for funds. While funds are a basket of different assets that are managed by professionals, ETFs are collections of similar assets.
For example, the energy select XLE index ETF tracks the performance of top energy stocks in the US.
Dollar-based ETFs are great ways of denominating your assets in dollars. You may need to speak to an investment professional to help you set up your current portfolio to accommodate these ETFs.
- Hard currency – dollars
This is a crude way of diversifying into the dollar as it is both expensive and risky to keep hard currency. However, if all other options aren’t feasible for you, this may suffice.
Now that the Naira has been allowed to trade freely in the parallel market, getting your hands on dollars shouldn’t be much of a problem.
Risks involved in hedging
- Basis risk
Basis risk in hedging arises when the price movements of the hedged asset and the chosen hedging instrument are not properly correlated.
This could potentially lead to losses. This discrepancy means the hedge may not completely protect against adverse market changes.
For example, if I have 90% of my assets denominated in Naira, and only 10% in Dollars, a sharp decline in the Naira may not be compensated by the meager 10% dollar-denominated allocation.
- Higher hedging costs
As we have seen with most of the hedging methods outlined in this article you would most likely involve a third party in the form of a financial adviser, banking house, or a broker.
These services are not free! This is one of the risks involved with hedging. Exorbitant commissions from brokers, jaw-dropping consulting fees, and hidden charges may erode the upside of hedging.
- Knowing when to de-hedge
To be on top of the investment or speculation game, you must have a good sense of timing! You need to be able to decipher and unclutter the confusing data the markets and the economy are giving!
In the end, this should help you know when to engage and close your investment positions. The same applies to hedging.
As we have seen in the previous section, hedging can be expensive, you want to make sure you close your hedged position when it has overstayed its importance.
For example, if I have been hedging my Naira-denominated assets by purchasing dollar bonds and currently the ratio of my dollar to Naira assets stands at 90:10, I should consider converting some portion back to Naira.
This is because the gains we have seen in the past ten months of this year could easily be eroded as the government rolls out better economic policies.
With properly hedged positions, theoretically, it is impossible to record losses but with abysmal entries and exits, you may give back substantial gains to the marketplace.
Timing is necessary for optimal returns. One of the best timing ideologies is from the great investor Warren Buffet. He is quoted as saying, “Be fearful when others are greedy and greedy when others are fearful”.
This passes right over the heads of many investors and speculators but time and time again, the markets and economy have shown that rebounds happen when the doomsday prophecies are thundering the loudest, and sharp declines happen when euphoria is at its peak!
Prudent investors and business owners are proactive. They do not wait for the economy or market sentiments to happen to them.
Like the Virgin Atlantic executive referenced in this article, you must look out for the interest of your finances and business first. Employ legal means like hedging to ensure that you are not at a disadvantage.
Great article worth reading.