How to hedge against currency volatility
The value of any currency can, and does, fluctuate 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 have a material impact on the value of currencies, dependent on the outcome of said events.
The aftershocks of the Brexit referendum are still being felt, with the value of sterling more often than not the first respondent to current Brexit sentiment.
Prior to the Brexit vote in June 2016, Irish exporters were comfortable with the euro trading in a £0.70 to £0.80 range, with limited volatility. Since then, however, sterling has continued to depreciate in excess of 20pc, trading consistently above £0.80, and reaching levels close to £0.93 over the past few weeks. The challenge posed by sterling at these levels is twofold.
Firstly, in the case of longer-term contracts, the euro value of these revenue streams is now significantly less, unless a long-term hedge is in place. For those who have not hedged the value of their sterling revenues, net margins are increasingly squeezed.
Secondly, a greater challenge relates to new tenders where Irish exporters are finding themselves increasingly uncompetitive relative to UK competitors.
Even if the Irish exporter is successful in a tender where margins are tight, the challenge of achieving a profitable contract is more difficult when currency fluctuations can erode profitability.
To help explain some hedging strategies available, imagine you are the chief financial officer (CFO) of a manufacturing company facing currency fluctuations. You have just won a contract to supply a new UK customer, but your customer will be paying you in sterling and as an Irish entity reporting in euro you will have to exchange this sterling for euro. This foreign exchange exposure should ideally be managed in such a way that it doesn't erode profit margins built into the sale price of the product.
Your UK customer will be paying you £100,000 (€113,000) monthly for 12 months, a total of £1.2m. Your company board has set you a 'budget rate' (breathing space in essence) of £0.92 for that exposure against a current market rate of £0.89. So any sterling that you may exchange under the £0.92 level is additional margin/profit, and alternatively any sterling you exchange over the £0.92 level will therefore eat into margin/profit.
In this scenario we present four different approaches.
The first is spot conversion, which risks the greatest exposure to currency fluctuations. In this scenario, the CFO elects to convert currency as and when required during the contract, at prevailing market rates. Such an approach provides no certainty over the euro value of the cash flows for the remainder of the year, and no certainty over profit margins on this contract. In any favourable currency move, the CFO will benefit from the increased euro value of the sterling cash flows, but should sterling continue to depreciate, the contract may become loss-making and, most worryingly, there is no worst-case scenario.
A second option is to use forward contracts. For the period of the contract, the CFO can fix the euro value of sterling revenues using forward contracts. A forward rate is calculated as the current spot rate on the day of execution, adjusted for the interest rate differential between the bought and sold currencies, and is currently below the budgeted rate of £0.92. In this case, the CFO will have certainty of euro cash flows and increased profit margin relative to costing rate, but an inability to benefit further in any sterling appreciation over the period. As part of this approach, the company will require a forward credit line to be provided.
Then there are so-called "vanilla options", which are similar to insurance premiums. You pay an upfront charge in order to gain the right (but not the obligation) to protect a certain rate for a certain future date. This gives reassurance you have a worst-case rate protected while being able to participate in any favourable market moves. But costs can be high and are dependent on the rate, future date and level of market volatility at the time of execution.
Finally, you could use structured solutions. Similar to vanilla options, these offer you protection at a certain rate at a certain future date. You can utilise that bit of 'breathing space' (£0.89 - £0.92) you have to discount the 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. There is no 'up front' charge and full protection at a worst-case rate, plus some participation in favourable moves. However, the product may have a structure that could push you into execution at the worst-case rate.
Justin Doyle is a treasury dealer at Investec