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Nakuru Auto Parts: Hedging a USD 1.5 Million Net Payable on a 4% Margin

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Nakuru Auto Parts: Hedging a USD 1.5 Million Net Payable on a 4% Margin

Nakuru Auto Parts imports components and exports a small volume of finished parts. In 90 days it must pay USD 2.4 million to a supplier and will receive USD 0.9 million from an overseas customer. Spot KES/USD is 129.50/130.10; the 90-day forward is quoted 131.40/132.20. Ninety-day KES interest rates are 12.0% and USD rates 4.5%. Annual sales are KES 900m and the net margin is 4%. The finance director wants to 'wait and see' because the shilling has been stable for two quarters. A bank has offered a 90-day USD call option at a 2.0% premium to cover the exposure. The company's policy is silent on hedging, and there is no treasury committee.

1. Quantify the net exposure and its materiality to profit. Is 'wait and see' defensible?

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Net exposure: USD 2.4m payable less USD 0.9m receivable = USD 1.5m net payable. Hedging the gross 2.4m would over-hedge by 0.9m and create a new speculative position in the opposite direction.

Materiality:

  • Profit = 900m x 4% = KES 36m
  • A 1% move in KES/USD on USD 1.5m = 1.5m x about 1.30 = KES 1.95m
  • As a share of profit: 1.95/36 = 5.4% of annual profit for every 1% currency move

A 5% depreciation - entirely ordinary for the shilling - wipes out over a quarter of profit. A company earning 4% net cannot absorb that from operating improvements; the hedge is not a treasury nicety, it is the difference between hitting and missing the year.

'Wait and see' verdict: not defensible. Two stable quarters is not a forecast, and the position is unhedged by default rather than by decision. The absence of a policy and a treasury committee means nobody has ever defined the firm's risk appetite - that is the governance failure sitting underneath the market call.

2. Compare the forward with the option, including a break-even rate, and check whether the forward is fairly priced.

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Forward: the bank sells USD to the company at 132.20.

  • Cost = 1.5m x 132.20 = KES 198.30m
  • Versus unhedged at today's 130.10 = KES 195.15m, i.e. KES 3.15m paid for certainty (1.6% of the exposure).

Option: premium 2.0% of notional at about 130 = 1.5m x 130 x 0.02 = KES 3.90m, paid whether or not the option is used.

  • Break-even rate = 132.20 + (3.90m/1.5m) = 134.80. The shilling must depreciate a further 3.6% beyond the forward rate before the option beats the forward. The option costs more than the forward in the likely case and only wins in the tail.

Is the forward fair? Mid spot 129.80, mid forward 131.80: premium = 2.00/129.80 x 4 = 6.16% p.a. against an interest differential of 12.0% - 4.5% = 7.50%. Covered interest parity would put the forward at 129.80 x 1.03/1.01125 = 132.21. The quoted mid is about 41 cents cheaper than parity, so forward cover is mildly attractive relative to a money-market (borrow KES, buy spot) hedge.

Caveat: the bank's 0.80 bid-offer spread is 0.61% of spot - about 2.4% annualised - and it consumes most of that theoretical edge. The offer rate of 132.20 is effectively parity. Get a second quote.

3. Recommend a hedging action and the policy the board should adopt.

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Action now: buy USD 1.5m forward at 132.20 for the 90-day date, locking the cost at about KES 198.3m, i.e. 1.6% above spot but fully budgetable. Do not buy the option as the primary hedge - at a 2% premium it costs 10.8% of annual profit and needs a 3.6% depreciation just to draw level; it is a bet dressed as risk management. Do not leave it open: the exposure is 5.4% of profit per 1% move.

Where an option can be justified: a small strip (for example 25% of the exposure) if the board genuinely wants to retain upside on a large depreciation, funded by selling a put to reduce premium - but only with the collar's downside quantified and understood.

Policy the board should adopt:

  1. Written hedging policy with a defined hedge ratio band (for example 70-100% of net exposure measured after natural offsets) and a named treasury committee.
  2. Hedge the net exposure, netted at least monthly, with counterparty limits and ISDA/IFEMA documentation in place.
  3. No directional views taken in treasury; deviations from the band require committee minutes.
  4. Mark-to-market and hedge-effectiveness reporting to the board monthly, with the accounting treatment (hedge accounting or not) documented before the trade.
  5. Competing quotes from at least two banks to erode the 61bp spread.