FX Hedging, Net Exposure and Covenant Headroom at Ladipo Auto Components
Ladipo Auto Components Ltd manufactures in Ogun State and exports to ECOWAS. It expects USD 8m from a Ghanaian customer in 90 days and must pay EUR 3m to an Italian equipment supplier in 60 days. Spot rates are ₦1,520/US$ and ₦1,650/EUR. The 90-day USD forward is ₦1,585; the 60-day EUR forward is ₦1,675. USD borrowing costs 9% and NGN borrowing costs 22% per annum; EUR borrowing costs 4%. A 90-day USD put option with a ₦1,560 strike costs a 3% premium. The company has a US$5m term loan due in 12 months and a covenant of net debt/EBITDA ≤ 3.0x; the ratio is currently 2.9x. EBITDA is ₦4.2bn and net debt is ₦12.2bn. The treasurer proposes either doing nothing, because 'the naira may appreciate', or using forwards for the entire USD exposure. The board wants a recommendation that protects the covenant and preserves upside.
1. Quantify and compare a forward hedge with a money-market hedge for the USD 8m receivable. What does the result imply about forward pricing, and what would you recommend?
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Forward hedge: USD 8m x ₦1,585 = ₦12.68bn in 90 days.
Money-market hedge: Borrow USD now so that the receivable repays the loan: USD 8m / (1 + 9% x 90/360) = USD 7.824m. Convert at spot ₦1,520 = ₦11.893bn. Invest at 22% for 90 days: ₦11.893bn x (1 + 22% x 90/360) = ₦12.545bn. The forward gives about ₦135m more.
Interpretation: the 90-day forward points are 65; annualised forward premium = 65/1,520 x 360/90 = 17.1%, versus the interest differential of 13%. The forward is priced rich relative to the synthetic money-market hedge, but it removes uncertainty and requires no upfront cash. The result assumes Ladipo can invest at 22%; if its deposit rate is lower, the forward advantage is larger. Recommendation: use the forward for the committed portion, but first net the exposure (see next task). Do not use the option for the whole amount: 3% premium on USD 8m = USD 240,000 = ₦365m upfront, with a floor of USD 8m x ₦1,560 - ₦365m = ₦12.115bn, which is lower than the forward and costly.
2. Identify Ladipo's true FX exposure, including the USD loan and EUR payable, and recommend a hedging approach that protects the covenant without eliminating upside.
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Net exposure is the key. The company has a USD 8m receivable (asset) and a USD 5m term loan (liability): net USD asset of USD 3m. Hedging the full USD 8m would create a net USD short of USD 5m and remove the natural hedge provided by the loan. If the naira depreciates, the USD loan increases in naira terms; the unhedged USD receivable would also increase, offsetting part of that. So the treasurer's proposal is not optimal.
Covenant stress: net debt is ₦12.2bn and EBITDA ₦4.2bn = 2.90x. The USD 5m loan is ₦7.6bn at ₦1,520. A 15% depreciation to ₦1,748 increases the loan by about ₦1.14bn; net debt becomes ₦13.34bn and the ratio 3.18x, breaching 3.0x. Hedging the receivable alone does not fix this; the company should either (i) use USD 5m of the receivable to prepay the USD loan if permitted, leaving USD 3m to hedge, or (ii) hedge the net USD 3m and seek a covenant waiver or headroom, or (iii) refinance part of the USD loan into naira if the interest differential is acceptable.
EUR payable: EUR 3m x ₦1,675 = ₦5.025bn. There is no natural EUR asset, so hedge it with a forward or money-market hedge. If some ECOWAS customers can be invoiced in EUR, create a natural hedge. Otherwise, buy EUR forward for the committed amount; do not leave it open.
Recommendation: (1) confirm whether the USD loan can be prepaid; (2) hedge net USD 3m with a forward; (3) forward the EUR 3m payable; (4) keep a small option overlay only for uncertain receipts, not the whole exposure; (5) set a hedging policy with 50-80% cover of committed exposures, prohibited speculative positions, and board reporting.
3. Explain the hedge accounting and treasury governance requirements the board should put in place.
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Hedge accounting: IFRS 9 requires documentation at inception, a designated hedging relationship and an economic relationship. Forward points and option premiums can create P&L volatility if the company does not apply hedge accounting. For a cash flow hedge of the USD receivable, the effective portion goes to OCI and is recycled when revenue is recognised. For the EUR payable, the hedge of a firm commitment can be a fair value hedge or cash flow hedge. The company should document the risk management objective, hedged item, hedging instrument and effectiveness testing. If it uses options, the time value may be deferred in OCI and amortised. Without hedge accounting, derivatives are measured at fair value through P&L, which may distort EBITDA and covenant ratios if the covenant uses reported EBITDA.
Governance: the board should approve a treasury policy with (i) identifying and netting exposures; (ii) permitted instruments (forwards, options, swaps, natural hedges); (iii) tenor limits, for example maximum 12 months; (iv) counterparty credit limits and ISDA documentation; (v) segregation of duties between dealing, settlement and confirmation; (vi) monthly mark-to-market reporting; and (vii) no speculative trading. The treasurer's 'do nothing because the naira may appreciate' is a view, not a policy. The board should also disclose FX risk, hedge accounting and covenant sensitivity in the annual report.