How to hedge your bets
As we all are fully, fully aware of, in June 2016 the United Kingdom voted to leave the European Union – a moment most didn’t think possible and many will never forget. This “shocking” decision ignited a wave of financial market volatility spanning the globe. For example the British Pound lost a whopping 18% of its value between May and October 2016 alone, with a drop of almost 10% in the minutes following the announcement on that fateful night.
The instantly weaker Pound caused particular pain to Irish SMEs exporting to the UK. Revenue for their goods and services dropped by 10% overnight, continuing to reduce in the days following the aftermath of the vote, with many firms suffering devastating losses. A number of Irish mushroom producers went bankrupt, suffering combined estimated losses of over €7,000,000. In a survey conducted by the Irish Exporters Association (IEA), 65% of members stated that a weakened Sterling had negatively impacted their business.
InterTrade Ireland’s recent Business Monitor survey showed that 71% of businesses with cross-border sales had less than a 10% profit margin and yet 91% commented that they had made no plans to deal with Brexit and its consequences. This is a shocking statistic, especially since foreign exchange exposure can be managed and the risk mitigated. But the 91% is evidence that most SMEs continue to bury their heads in the sand.
Business owners and managers take insurance out against all sorts of risks; product liability, general liability, property, commercial auto, theft, key man and so on – yet appear to do nothing to protect against foreign currency fluctuations. Solutions are available for those who wish to address the issue and take action.
The first step to develop a currency risk management plan requires an understanding of your risk – what gets measured gets managed. Calculate your net FX exposure by considering both payments and receipts. Occasionally, risks can be ‘naturally hedged’ and thus lowering exposure. Again, this seems obvious, but it would amaze you the number of businesses we speak with that don’t know at what point their business becomes unprofitable due to FX movements.
Once FX risks have been identified, the next step is to formulate your currency risk management policy. Considerations may include the firm’s overall risk appetite, competitive situation and how currency movements affect this, financial reporting and hedge accounting implications i.e. the types of hedging tools the business will utilise. Many SMEs seek the help of a bank, FX provider, independent treasury advisor, or a consultant to formulate this policy.
The final part of the currency risk management plan is to execute the policy. The most commonly used hedging execution instruments are FX forwards and FX options.
FX Forwards
An FX forward contract is an agreement to purchase or sell a set amount of a foreign currency at a specified price for settlement at a predetermined time in the future. For example, an Irish exporter to the UK ‘sells forward’ £100,000 he expects to receive three months into the future at a rate of €1 = £.8875 (some look at rate in terms of Euro per Pound i.e £1 = €1.1267). This forward contract allows him to convert his receipt of £100,000 into €112,670 in three months’ time.
The main advantages of a forward contract are that it eliminates downside risk by fixing a rate, the coverage amount and timings are fairly flexible, and its relatively easy to understand implement.
However, there are disadvantages, too. Once a forward hedge is locked in, the business foregoes the possibility of any currency gain. A forward is a strictly contractual commitment that must be settled in the exact amount and timing that is agreed. A down payment, called a margin, is often required by providers and very often additional further margin payments can be requested therefore making it difficult for SME cashflow planning. Also, many smaller firms are excluded from gaining access to this product due to their size.
FX Option
An FX option is a contract that gives the buyer the right, but not the obligation, to exchange foreign currency at a specified price for settlement at a predetermined time in the future. The purchaser of the ‘option’ pays a relatively small upfront premium and in return can choose to exchange the foreign currency if they wish to – but are not under any requirement to do so. It works in a similar way to the FX forward with the key difference being it acts more like ‘currency insurance’ against unfavourable FX movement.
The main advantages of an option contract are that is protects against downside risk while at the same time enables FX gains to be made. The hedging cost is known and paid upfront and therefore cash flow planning is easier than with a forward. The instrument has no credit implications and therefore is suitable for businesses of all sizes. It’s a very flexible instrument and can be tailored to the customers exact requirements, for example some businesses might only require protection from extreme FX moves and this will bring the cost of the premium significantly. Options can be sold back to most providers if requirements change, with some or all of the premium being recouped.
The main disadvantage of an FX option is that a premium must be paid up-front by the purchaser, in a similar way to how one would buy a typical insurance product. The cost of the premium can change due to the effects that volatility has on it.
If your business is exposed to FX risk then, much like every other aspect of your operation, it’s best to investigate ways to lessen any exposure. Hedging your bets is the way to go.
Barry McCarthy is the CEO of Assure Hedge, an FCA regulated provider of hedging services to SMEs. He can be reached at [email protected].