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Brexit and the management of exchange rate fluctuations

One of the biggest challenges arising from Brexit is the management of exchange rate fluctuations. For many owner managed businesses (OMBs) this can be something that they are not entirely comfortable with.  Clearly the decline of the ranking of Sterling as a major reserve currency will lead to greater volatility, and therefore OMBs will need to be more aware of currency hedging techniques.

This article discusses the process of hedging, and explores some of the strategies OMBs can utilise to mitigate their exposure to volatile exchange rates.

What is hedging?

The easiest way to understand hedging is to think of it as insurance. When people decide to hedge, they are insuring themselves against a negative event. This doesn't prevent the negative event from happening but, if it does happen, and you're properly hedged, the impact of the event is reduced. So hedging occurs almost everywhere, and we see it every day. For example, if you purchase house insurance, you are hedging yourself against fires, break-ins or other unforeseen disasters.

Foreign currency hedging specifically tries to reduce the risk that arises from future movements in exchange rates. This is obviously a two-way risk since exchange rates can move adversely or favourably. However, with the impact of Brexit, management would generally be hedging for adverse movements only.  Hedging can provide certainty of cash flows, which helps with budgeting, encourages management to undertake investment and reduces the possibility of financial collapse.

What are the main currency hedging techniques?

(a) Foreign currency bank accounts
These are ideal when there are receipts and payments in the same currency. For example, UK businesses that are actively trading with Eurozone countries may use receipts in Euros to cover payments to European suppliers. This will avoid, at least in part, exposure in the Euro whilst at the same time eliminating conversion costs incurred when buying and selling currency.

All major banks offer bank accounts in a wide range of currencies, but it is worth conducting some research to see which ones will pay interest on credit balances and are competitive on debit interest rates should the need arise.

(b) Forward contracts
Businesses can use forward contracts to sell or purchase foreign currency amounts at a future time and a given exchange rate. The settlement takes place at the time and the exchange rate mentioned in the contract, regardless of any fluctuations of the exchange rate on the foreign exchange market.

(c) Flexible forward transactions
A flexible forward transaction has the same characteristics as a forward contract transaction with one specific difference. The difference being that the settlement of the transaction can take place at any time until the maturity of the contract. The business may choose to make partial settlements for its transaction at any time until the maturity of the contract, having the only obligation to exchange the entire notional amount until maturity.

(d) Options
Options give the buyer the right but not the obligation to sell/buy a specific amount at a pre-agreed exchange rate. In order to have this right, the business pays a premium.  An option contract has the same functionality as an insurance contract. The business pays a premium in order to be able to take advantage of its right in case a certain event occurs.

The Call option gives the buyer the right but not the obligation to buy a specific amount of currency at a pre-established rate in exchange of a premium paid (the cost of the option).

The Put option gives the buyer the right but not the obligation to sell a specific amount of currency at a pre-established rate in exchange of a premium paid (the cost of the option).

(e) Currency Swaps
A currency swap transaction represents an agreement to exchange one currency for another at an agreed upon exchange rate. There are two simultaneous transactions, one of buying and one of selling the same amount at two different value dates (usually Spot and Forward) and at exchange rates (Spot and Forward) that are pre-agreed at the moment when the transaction is closed.

The spot rate is the exchange rate for a currency at the current time.  Whereas, forward rate is a rate for purchase of foreign currency at a fixed price for delivery at a later date

In a currency swap, the holder of an unwanted currency exchanges that currency for an equivalent amount of another currency. Thus, the business exchanges his interest and currency rate exposures from one currency to another or benefits of bank financing at a lower rate.

So what now….?

Businesses should consider their exposure to foreign currency fluctuations and consider whether the various hedging options are suitable for them.

Should you wish to discuss these options further, please do not hesitate to contact your usual Moore contact.

Further information on the issues likely to impact businesses as a result of Brexit; visit our dedicated Brexit microsite here.