Although most of the UK population warmly welcomed the award of the 2012 Olympic Games to London, a few have expressed concern about its cost. This is not surprising, modern Olympics have after all frequently cost more than originally estimated. The 2004 Athens Games, for example, went more than $1.7 billion over budget.
A glance at the detailed budget of the London Organizing Committee for the Olympic Games (Locog) will immediately raise concerns among the doubters. Locog says the "forecast budget... has been prepared in a prudent manner with a conservative revenues forecast, cautiously projected expenditure and a contingency of $105 million." Locog's total budget is put at $2.462 billion, which covers expenditure on running the Games, not the cost of investment in new infrastructure.
What seems really odd about the budget is not necessarily its denomination in dollars, even though most revenue and expenditure is in sterling, but the sterling/dollar rate chosen. This was set at $1.60 when the budget was finalized in October 2004.
At the time, the rate was around $1.84, pretty much where it is at the moment. So Locog's budget, in sterling, was set at £1.538 billion. If it is assumed this sterling budget remains constant, the dollar cost is now $2.831 billion. This implies that the Games are already running around $370 million over budget.
According to Neil Wood, Locog's finance director, the rate used is the medium-term to long-term equilibrium rate, which is supported by the economic fundamentals rather than the spot rate at the date of preparation of the budget.
However, as Lorenzo Codogno, co-head of European economics at Bank of America in London, points out, the long-term equilibrium rate effectively does not apply to the real world. "The problem is that if you have to fix an FX rate for a long-term project, you basically have to go for either an equilibrium model or a market forecast," he says. "Long-term FX rates are extremely hard to predict, and therefore forecasts may not be the best way to go. But you can certainly argue that a long-term equilibrium rate significantly far away from spot rates may equally be not fully appropriate."
Wood agrees that not using the market rate might appear odd. He adds that Locog, unlike a company, which will typically budget on a one-year or two-year horizon, has had to overcome an extremely unusual budgetary exercise looking at expected revenues and expenditure far further out on the time horizon.
He adds that about 75% of the budget is naturally hedged through a mix of matched currency income and expenditure and significant non-monetary elements of the budget. This leaves about $675 million ostensibly exposed to exchange rates; Locog says it will put hedging strategies in place to mitigate the risk of any remaining currency exposure. The International Olympic Committee's proposed contribution of $600 million from broadcasting rights is included in this unhedged portion of the budget.
If this unhedged FX exposure is marked to market, it appears that there is already a budget shortfall of about $97 million. In other words, the contingency fund has almost been wiped out before Locog has even started digging the foundations for the Olympic stadium.
Another banker points out that although it would have been more sensible to use a market rate for the budget, careful consideration would have still been required to hedge the dollar exposure. "The committee faces the problem of FX contingency risk if it simply does an outright hedge. Both expenditure and revenues will be variable and it would be easy to over- or under-hedge," he says.
He adds that given the long-term horizon of the project, some fairly simple exotic structures could be used to hedge cheaply, flexibly and efficiently. Starting with a realistic sterling/dollar rate in the budget would undoubtedly have made this easier.
Wood denies that Locog is over-reliant on the sterling/dollar rate falling over the next few years. "The reality is we haven't actually firmed up what currency certain contributions will be in. For instance, the IOC will sell some of the broadcast rights in euro; we will get certainly get a portfolio of currencies," he says.
This is probably just as well, otherwise Locog will have to hope that the Olympic motto of "citius, altius, fortius," or faster, stronger, higher, does not characterize sterling over the next seven years.
For the moment, Locog is confident. "I'm absolutely confident we'll not go over budget," concludes Wood.