Currencies: Hedging your bets

The perceived haven properties of sterling on international currency markets generate a clear problem for British business: a strong pound makes exports more expensive.

At a time when domestic demand is also under pressure from faltering consumer confidence and a return to recession, the impact of adverse currency movements on competitiveness abroad adds a fresh layer of difficulty.

For companies, this makes mitigating the impact of a strengthening pound all the more important, and there are four main types of financial instruments that can be utilised to soften the blow.

Options contracts come in two types. “Call” options give a company the right, but not the obligation, to buy a currency at a predetermined price within a defined time frame. A “put” option allows the company to sell at a certain price, and within a defined time frame.

Futures contracts provide a standardised way to buy or sell currency at a set price and a set time, both defined at the time the contract is drawn up. Because the contracts are standardised, they can be subsequently traded on exchanges.

Forward contracts work in a similar way, and tend to be drawn up between banks or brokers, with the price of the sale or purchase also agreed at the time the contract is written. But because they are private contracts, they cannot be traded among third parties on open exchanges.

Carry spot trades allow companies to take long or short bets on the value of a currency, funded in another, in order to gain positive exposure to a relative change in value that might otherwise add to a business’s costs.

Michael Stumm, co-founder of Oanda Corporation, the operator of the fxTrade website, offers an example. “You are a small company in the UK that has an accounts payable of €250,000, due in three months,” he says. “In order to protect yourself, you can buy €250,000 using sterling, thereby eliminating any currency exchange risk, since you will be getting today’s rate. It doesn’t matter if the euro goes up in value or down as you are controlling a €250,000 euro position in your account thus ensuring you have hedged the full amount of the pending payable.”

The impact of such strategies on business can be significant, and the current volatility on foreign exchange markets means they are becoming more popular.

Philip Evans, director of strategy and business development at Ramsden International, a food exporter, is looking into adopting hedges, and says the currency market is becoming “more influential” as the business grows.

“Historically, we have sold only in sterling. But customers’ memories tend to only go back a year or so, and as we need to avoid looking uncompetitive, exchange rates are becoming more of an issue. For some larger customers we now need to invoice in local currencies, but with longer-term contracts, with payment terms of up to 90 days, you have to evaluate factors influencing margins, and the volatility of the currency market is an important part of that. It’s not all easily predictable. The issue is one of balancing competitiveness and risk and that has started to move against exporters.”

Sarah French, finance manager at IT4Automation, started using currency hedging four years ago, after becoming aware that the business, which distributes networking products, was paying more than it needed to in euros for products bought from Taiwan.

“We brought in specialist help to reduce the frequency with which we had to revise prices, as well as to keep down our euro-costs. We were not getting a great exchange rate through the banks, and we also had to pay transaction costs.

“The services offered by our hedging provider have been more flexible and offer us greater clarity. I have three forward positions at the moment, and can look at them at any time. For us, it definitely has worked, and has also been cost effective. If I was marking our strategy out of 10, I would give it a nine, although we remain aware there is an element of risk, and the [currency] price can always go against us.”

One chief executive of a medium-sized company based in the south-east of Britain says that the pound’s ascent would need to be steeper before it became necessary for his business to take action. He also says that many exporters buy parts or raw materials from abroad, which can act as what he termed “an internal hedge” against a strong pound.

Oanda’s Mr Stumm points out that some hedging strategies are more complicated than others: “Banks typically generate more revenue from selling options than from selling the other instruments used in hedging.

“Options are relatively complex derivatives, and unless you fully understand the maths behind options pricing, you cannot know if you are getting a good deal or not. Hence, we recommend clients stay away from options unless they have a financial background.”

Angus Campbell, head of market analysis at London Capital Group, said the demand for the hedging services he provides is growing as the currency markets remain turbulent.

“With the outlook for the eurozone still very unclear, we would expect to see more clients use our foreign exchange platform for hedging purposes. A simple and effective way for exporters to mitigate risk is to buy or sell those currencies that they are exposed to in order to protect themselves against any adverse fluctuation in the exchange rate.”