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How to protect your Naira-denominated assets by diversifying into Dollar-based assets

In the face of a staggering 49% decline in less than a year, the Naira, Nigeria’s currency, is treading dangerously close to historic lows. The unsettling journey from N735/$ on January 1, 2023, to the current trading rate of approximately N1145/$ has prompted concerns among investors as the erosion of wealth stored in Naira denominations becomes increasingly evident. In response to this economic challenge, many investors are turning to a strategic approach known as hedging to shield their Naira-based assets from further depreciation.

Hedging is not a pursuit of wealth generation but rather a strategy for safeguarding existing assets from depreciation. It involves making opposite investments in related assets to counteract potential losses from underperforming investments. For instance, if the value of a specific stock is rapidly declining, an investor may choose to open a leveraged short position. Profits from this short position can then offset the losses incurred due to the depreciation of the stock.

This risk management technique is particularly popular among currency pair speculators who leverage it to diversify into stronger currencies. The rationale is to mitigate risks associated with holding assets in a single currency, especially when currency values fluctuate.

The emphasis on diversification as a risk mitigation method must be balanced. The age-old adage “Do not store all your eggs in one basket” holds in the investment landscape, highlighting the perils of concentrating financial assets in one currency or asset. Such concentration exposes investors to serious portfolio losses if the chosen asset underperforms.

Challenges Faced by Businesses in Nigeria

Multinational companies operating in Nigeria are grappling with significant challenges stemming from the weakened state of the Naira. A notable example is Multichoice, the parent company of DSTV and GoTV, which has reported consecutive months of losses attributed to the poor performance of the Naira.

Various Hedging Strategies

Several hedging strategies can be employed to mitigate the risks associated with Naira depreciation:

  1. Asset Allocation: Investors may choose to allocate percentages of their assets to opposing assets, thereby mitigating risk.
  2. Futures and Options: Derivatives such as options and futures can be utilized to hedge against currency fluctuations.
  3. Trading on Haven Assets: Investing in assets like the US Dollar, Gold, Silver, and other precious metals known for maintaining value during market declines provides a hedge against currency depreciation.

Dollar-Based Assets as a Hedge Against Naira Depreciation

To counteract the impact of Naira depreciation, investors are advised to consider dollar-based assets:

  1. Dollar Funds: These are investment funds denominated in US dollars, offering returns in the same currency.
  2. Dollar-Based ETFs: Exchange-Traded Funds denominated in dollars provide a diversified approach to asset allocation.
  3. Hard Currency (Dollars): Directly diversifying into the dollar, though potentially expensive and risky, is also considered.

Risks Associated with Hedging

While hedging provides a shield against Naira depreciation, it comes with its own set of risks:

  1. Basis Risk: Arises when the movements of the hedged asset and the chosen hedging instrument are not properly correlated.
  2. Higher Hedging Costs: Involving third-party fees, consulting charges, and potential hidden costs can erode the benefits of hedging.
  3. Knowing When to De-Hedge: Understanding when to exit a hedged position is crucial for optimal returns.

The Role of Timing in Hedging and Proactive Financial Management

Proper timing is emphasized as a critical factor in making informed investment decisions. The wisdom of Warren Buffet’s advice, “Be fearful when others are greedy and greedy when others are fearful,” underscores the significance of strategic timing in the financial landscape.

Prudent investors and business owners are urged to adopt a proactive approach, employing legal means such as hedging to protect their finances and businesses from the market’s uncertainties. In conclusion, the effective navigation of Naira depreciation requires a comprehensive understanding of hedging strategies, a commitment to diversification, and a keen awareness of market dynamics.

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