Protection against currency volatility has never been more relevant than in the run-up to the UK EU referendum on June 23, with sterling experiencing significant swings in value because of speculation about the impact Brexit might have on the UK (and indeed the wider European) economy.
Matthew Ryan, a strategy analyst at financial servces provider Ebury, observes that implied volatility in sterling, widely seen as the most accurate measure of foreign exchange market fears about Brexit, has increased drastically since the turn of the year. Both one-year and six-month implied volatility in sterling/US dollar are higher than the same measures for euro/US dollar, having been lower ever since the introduction of the single currency in 1999.
Ryan expects that in the immediate aftermath of a Brexit majority vote, sterling would depreciate approximately 10% against the dollar and 5% against the euro, while suggesting that a Remain vote and the clearing of uncertainty would bring about a sterling rally of roughly half that amount against the US and European currencies.
Earlier this month, analysts at FxWirePro recommended that companies hedge dollar-denominated expenses up to three months ahead to protect against any short-term euro/dollar decline prompted by a Leave vote.
Danske Bank analyst Morten Helt notes that for companies with sterling-denominated expenses, the recent increase in euro/sterling, together with the forward premium, has made it possible to hedge sterling expenses at what would be attractive long-term levels in a Remain outcome.
Given the risk of a substantial increase in euro/sterling in the event of Brexit, he recommends hedging around 50% of future sterling-denominated expenses via FX forwards.
The issue for corporates is that uncertainty and confusion over how Brexit would affect FX markets has made it much more difficult to implement forwards effectively as exchange rate volatility affects the predictability of costs, says Peter Theuninck, treasury manager at Earthport Treasury.
Amol Dhargalkar, leader of the global corporate team at risk manager Chatham Financial, agrees, suggesting that in some currencies corporates have shied away from hedging currency risk because of the forward points or cost of hedging.
Theuninck says: “That said, the value of a forward hedge can be diluted in two ways – the market-risk adjustment of the contract creates a loss on a company's profit-and-loss statement or the cash required to support the forward hedge could potentially limit a company's operational capabilities. It is for these reasons that forward hedges need to be employed strategically and only where the value risk is completely understood.”
Options offer more flexibility since option holders can benefit from currencies moving in their favour. Although the cost can be sufficiently high to deter companies from using them regularly, explains Dhargalkar, in many situations options might make sense. “When exposures are uncertain, or when the risk to the company is asymmetrical (embedded one-way options within contracts, for example), options may be far preferable to forwards.”
Aside from the discrete event of Brexit, FX hedging is par for the course for large corporates – with the human and technological resources to be ahead of the curve.
Bill Goodbody, senior vice-president of FX Bats Global Markets, refers to the use of zero-cost collars by some US corporates looking for protection whether the market moves favourably or not. 360 Trading Networks managing director Alfred Schorno,acknowledges that although options offer greater flexibility, they are normally an add-on to a corporate hedge strategy rather than the main tool.
A natural hedge is always the best option for corporates, adds Goodbody. “One of the main challenges corporates face is complete visibility of their company-wide exposures. More sophisticated corporates have a better grasp of their exposures and so have a better chance of benefiting from a natural hedge.”
Natural hedges are a trend to be followed for larger organizations, but not a one-size-fits-all solution for corporates, and they are normally only applicable in larger, economically stable currency regions, says Schorno.
According to Dhargalkar, companies are always looking to find natural hedges to reduce their overall cost of hedging.
He says: “Sometimes, natural hedges can be easy to find – one business unit may be long euro while another short euro and you may be able to set up an internal hedge entity to net risks for the firm. For many firms, though, the best natural hedge would be to be able to match the currency of revenues with costs. This may not be possible in the short or even long run for some companies and as such leads firms to utilize financial hedges to reduce overall volatility.”