Sterling slide poses hedging conundrum for treasurers

David Wigan
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UK corporate treasurers have been slow to react to the recent decline in the value of sterling, perhaps because of a misplaced sense of security after the recent period of low volatility, analysts say. For many, the key now is not to miss the hedging boat altogether.

The pound continued its slide against the euro and the dollar in recent days, after the UK lost its AAA credit rating and the governor of the Bank of England suggested he would inject more money into the economy through quantitative easing, shocking investors who had expected rate-setters to hold fire on further asset purchases.

Amid near-zero growth, Mervyn King was one of three members of the nine-strong Monetary Policy Committee to vote earlier this month for more liquidity, helping push sterling to its lowest level against the dollar in more than seven months and its lowest level against the euro in more than a year.

“UK companies that are selling foreign currency into sterling will be rubbing their hands with glee, but among those who rely on importing there is a slight sense of panic setting in,” says Daniel Harden, a senior dealer at Global Reach Partners, a London-based provider of FX solutions for corporates.

“There is a feeling that with sterling having fallen so far so fast, it has become difficult to know whether to hedge at the new levels or hope for some sort of rebound.”

Sterling has declined against the euro from 1.24 on the first day of the year to below 1.15, before rebounding slightly in recent days. The 7.5% swing represents more volatility than during the whole of last year.

UK corporates that need euros must make hedging decisions based on their current budget, Harden says. For example, if they have a budget of 1.10 euros against the pound then it makes sense to hedge their whole requirement in the forward market now, but if their budget is at 1.20 – a very common level of expectation for euro-sterling at the beginning of the year – it might make sense to hedge part of the exposure at the current level and try to manage the remainder higher on any rebound in the UK currency.

“If you are budgeted at 1.20, you obviously have a problem hedging at 1.14 and you may want to do some partial hedging now and take a view that we will see a bounce at some point following recent falls,” says Harden.

For treasurers loath to take positions in the forward market at current levels, an alternative might be to use an option overlay to protect against further weakening and retain some flexibility should the currency recover.

“For a small option premium, you can cover yourself against very sharp falls,” says Chris Turner, head of FX strategy at ING Financial Markets. “If you have a mandate to hedge your currency exposure at some proportion of your total, it certainly makes sense at this point to considering turning the dial up towards the upper limit.”

Despite the obvious recent drivers for increased hedging, relatively few UK corporate treasurers have taken action, says Turner. The one-year part of the option curve, the area most impacted by corporate hedging rather than speculation, was not priced to suggest high levels of activity, he says. The one-year sterling-dollar risk reversal skew was at 1.5% in recent trade, compared with the 3% you would expect if there was high demand for sterling puts.

Sterling one-year implied volatility, meanwhile, was around 9% in recent sessions. That compares with 7% at the beginning of the year, but is below the 14% it reached in 2011.

“Historically, it’s still not too expensive to buy options, and given the fact it could start to get pretty ugly for the currency, and that we might see a stronger dollar in the United States, it makes sense for treasurers to give consideration to these strategies,” says Turner.

Of course, decision-making over strategy is rarely linear. One company to have been historically vocal about FX hedging is Rolls-Royce, which transacts mainly in dollars but reports its earnings in sterling. The company reported a $22.5 billion hedge book in its 2012 earnings, compared with $22 billion the previous year. Ironically, its heavily hedged position might prevent it from taking the benefit of sterling’s decline.

Miner Rio Tinto, meanwhile, has adopted a very limited hedging strategy for its currency exposure, which is often tied to its commodity holdings.

Another reason for the slow uptake of options might be that many corporates have already put hedges in place, says Martin O’Donovan, deputy policy and technical director at the Association of Corporate Treasurers.

“For corporates that are properly hedged, short-term movements in currencies should not be too much of a problem,” he says. “The tougher proposition is when you see a more long-term secular move toward a weaker sterling. In that case, you may have to make more permanent changes, including a reassessment of your business model.”