Sunday 21 January 2018

Hedging your bets in the event of a Brexit

The City of London financial district. Photo: Bloomberg
The City of London financial district. Photo: Bloomberg

The value of any currency can and does fluctuate (sterling is down 14pc in the last three months) over time due to the many economic, fiscal or political vagaries that face any economy and in turn their domestic currency.

The outcome of certain 'risk events' can and sometimes do have a material impact on the value of currencies dependent on the outcome of said events.

The now imminent Brexit referendum is without doubt one of those 'risk events'.

So how can Irish companies protect themselves in such a scenario?

Case study: You're the CFO of a Munster-based company producing medical devices and have just won a UK contract. Great news, but the price will be fixed in sterling not euro, ie your customer will be paying you in pounds and as an Irish entity reporting in euro you will have to exchange for euro. This foreign exchange (FX) exposure should ideally be managed in such a way that it doesn't erode profit margins built into the sale price of the product - something that could happen with a major 'risk event' like Brexit looming.

Numbers: Your UK customer will be paying £100k monthly for 12 months, a total of £1.2m. Your company has set you a 'budget rate' (breathing space in essence) of £0.81 (£1 = €1.23) for that exposure against a current market rate of £0.78 (£1 = €1.28). So any sterling that you may exchange under the £0.81 level is additional margin/profit and alternatively any sterling you may exchange over the £0.81 level will eat into profit. So how can a bank like Investec help you hedge the risk?

Strategies: There are really four viable FX hedging strategies available to you:

1: Forward contracts - You can decide to cover your entire sterling (£1.2m) exposure with spot (on the day) and/or forward (longer dated) contracts at the current market rate of £0.78. Pros: Comfort of knowing that your entire exposure is hedged at a profitable £0.78 (vs. budget of £0.81). Cons: You can't benefit from favourable market moves, ie a lower EUR/GBP rate.

2 Vanilla Options - These are similar to insurance premia. You pay an 'up front' charge in order to gain the right (but not the obligation) to protect a certain rate for a certain future date. Pros: Confidence you have a worst case rate protected while being able to participate in any favourable market moves, ie a lower EUR/GBP rate. Cons: Costs can be high and dependent on the rate, date and level of volatility at the time of execution.

3 Structured Solutions - Similar to vanilla options, these products offer you protection at a certain rate at a certain future date. You can utilise that bit of 'breathing space' (£0.78 - £0.81) you have to discount option premium and allow you to participate in some portion of a favourable move in your direction in order to enhance or improve your overall average rate. Pros: No 'up front' charge/premium and full protection at a worst case rate. Cons: The product may have a knock in/out structure that could push you into execution at worst case rate.

4 Cross fingers and hope for the best - Not advisable. Pros: You could get lucky. Cons: If you're unlucky, such an approach could threaten your business.

Some top tips from Investec: There is no best practice when developing an FX hedging strategy but here are some guidelines:

1 Know your exposure.

2 Know how it affects your business.

3 Reduce your exposure as much as possible.

4 Be aware of how your competitors manage their exposure.

5 Be mindful of the alternative approaches and try to avoid too much exposure to any one rate or any one product.

6 You are trying to mitigate risk, not become a currency speculator.

While choosing the optimal strategy is tricky at best, we can help in formulating a weighted hedging portfolio tailored to your specific needs.

Justin Doyle is Senior Treasury Dealer at Investec, with offices in Dublin and Cork.

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