Hedging your currency bets
Recent fluctuations in the value of the pound due to market uncertainty have offered a strong reminder of the merits of currency protection
Sterling has been the nemesis of British business for much of 2014. Over the summer the pound hit its strongest level against the dollar since the 2008 financial crisis, wiping about £1 billion off the bottom line of big companies with foreign earnings.
Advertising boss Martin Sorrell of WPP complained that revenues had been "ravaged" by the adverse currency move, while drinks group Diageo said sterling had sliced almost £350 million from operating profits.
Since then, economists predicted that a Yes vote in the Scottish Referendum would cause the value of sterling to plummet. When it became clear that Scotland had decided to remain part of the UK, the pound surged.
Such volatility in currency value is music to the ears of currency traders, who earn a living by designing strategies to protect companies from foreign exchange fluctuations.
Forward thinking
An example of how currency hedging works:
Imagine a British exporter is expecting to sell widgets for €100 to a French firm and will be paid in six months. If euro-sterling is trading at 79p - the rate on 18 September 2014 - the English company can expect to receive £79 for its goods. But imagine the value of the euro falls against sterling to 65p. Then the British company will get only £65.
The company can protect itself in several ways. The most basic is to use a forward contract. In this deal, somebody else in the market agrees to supply euros in six months' time - or another time period - at a fixed rate. "Usually this is the cheapest and simplest technique," says Win Thin, a currency analyst at Brown Brothers Harriman.
Alternatively, the company could buy a sterling call option - giving it the right, but not the obligation, to purchase sterling at a determined price. If sterling falls, the value of this contract increases, helping to compensate for the fact that the company will receive less money from the French firm buying its widgets.Hedging currencies is essentially buying insurance against unfavourable shifts in foreign exchange. A currency hedge transfers the foreign exchange risk from the trading or investing firm to a business that carries the risk, such as a bank. In addition to the costs involved in setting up a hedge, the firm also forgoes any profit if the movement in the exchange rate would have been favourable to it.
"By not hedging currency exposure, businesses are taking a risk," says Marc Chandler, Chief Markets Strategist at Brown Brothers Harriman. "The value of buying this insurance is that you lock in certainty, which allows you to focus on running your business or managing your investments."
Of course, purchasing foreign exchange hedges does not make sense for all companies or financial firms. But it is a risk that few institutions can afford to ignore.
Foreign exchange swings can harm a firm in several ways. For a start, a surge in a company's domestic currency shrinks the value of profits from overseas operations. Exporters can face an unappealing choice between raising prices in overseas markets, imperilling their market share, or accepting slimmer profit margins. In turn, financial firms can see the home value of their foreign assets dwindle, along with streams of income from interest or dividend payments.
Cautionary taleIn extreme cases, such foreign exchange shifts can prove fatal. A cautionary tale was offered by the demise of Laker Airways in 1982, explains John Grout, Policy and Technical Director at the Association of Corporate Treasurers. "This was a low-cost airline flying Brits to the United States," he says. "Since most of its costs were in dollars and its revenues were in sterling, the firm was badly wounded by a sharp fall in the value of the pound."
Companies with such an obvious currency mismatch are particularly vulnerable. However, foreign exchange risks often come in disguise, says Grout.
"Currencies can be out of whack for very long periods of time""Even a company that makes and sells its goods in its home country can be exposed to currency perils if it has overseas rivals," he warns. Imagine a purely American carmaker that faces competition from Japan. "A fall in the yen would boost the revenue of these competitors, allowing them to spend more on marketing or cut prices," he explains. "Companies often forget about this hidden currency threat."
To hedge, or not to hedge?Of course, hedging does not always make sense - either for industrial or financial firms.
For investors, the decision whether to hedge or not partly depends on the assets they purchase, says Derek Halpenny, European Head of Global Markets Research at Bank of Tokyo-Mitsubishi in London. "It has often made more sense for bond investors to protect against currency risk," he explains. "Since fixed income investments are typically less volatile, a currency move can easily obliterate your returns." By contrast, equity managers have traditionally had less incentive to insure against foreign exchange swings, since stocks can rise and fall more dramatically.
Chandler agrees. "In a basket of international equities only about a third of the total return may come from currency movements," he says. "For bonds it can be more like two thirds."
Asset managers and pension funds also have a greater incentive to buy protection when investing in emerging or frontier economies. "The more volatile and illiquid the currency of the nation, the greater the need to hedge," says Halpenny. "The fluctuations in the Brazilian real or Indian rupee will be far greater than the movements of the euro under most normal circumstances. In even smaller economies, it may also be hard to buy and sell in a hurry."
Shifting productionOf course, hedging is not free. The cost of buying currency protection means that where possible, companies will seek other ways of reducing foreign exchange risk. "Financial hedging becomes more costly if you try to buy longer-term protection or shield yourself in the most turbulent markets," says Chandler.
For longer-term protection, companies can seek 'natural' hedges by shifting production to the country in which their goods or services are sold. "Currencies can be out of whack for very long periods of time," says Grout.
That gives companies a powerful reason to align the currency in which they pay their bills and the currency in which they receive their income. "Obviously there are many factors in deciding where to set up factories or other operations," says Grout. "But currency hedging is certainly a factor that companies will consider." Companies can also borrow in different currencies as a way of offsetting foreign exchange fluctuations.
Yet even the most carefully designed natural hedges seldom totally eliminate currency risks. Wading into the foreign exchange markets has become an inevitable cost of doing business for most international companies and investors.