21 June 2017

Brexit: managing exchange rate fluctuations

We define hedging and outline some of the strategies SMEs can adopt in order to mitigate their exposure to volatile exchange rates following Brexit.

One of the biggest challenges arising from Brexit is the management of exchange rate fluctuations, which is something many small and medium-sized businesses (SMEs) are not entirely comfortable with. To help manage this challenge, we discuss the process of hedging and explore some of the strategies SMEs can utilise in order 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 will be reduced. So, hedging occurs almost everywhere and we see it every day. If you purchase house insurance, for example, you are hedging against fires, break-ins and 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, when it comes to the impact of Brexit, management would generally be hedging for adverse movements only. In this circumstance, 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?

1. Foreign currency bank accounts

These are ideal when there are receipts and payments in the same currency (also known as a ‘natural hedge’). 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, should the need arise, it is worth conducting some research to see which ones will pay interest on credit balances and are competitive on debit interest rates.

2. 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 exchange rate referred to in the contract, regardless of any fluctuations of the exchange rate on the foreign exchange market.

3. 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 up until the maturity of the contract. The business also has the choice to make partial settlements at any time until the contract matures, with the only obligation being to exchange the entire notional amount until maturity.

4. 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 must pay a premium. An option contract has the same functionality as an insurance contract.

The ‘call’ option gives the buyer the right, but not the obligation, to buy a specific amount of currency at a pre-established rate after paying a premium (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 after paying a premium (the cost of the option).

5. 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 when the transaction is closed.

The spot rate is the exchange rate for a currency at the current time. Whereas, the 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 it for an equivalent amount of another currency. Thus, the business exchanges its interest and currency rate exposures from one currency to another or benefits from bank financing at a lower rate.

What next…?

Businesses should consider their exposure to foreign currency fluctuations and decide whether the various hedging options mentioned above are suitable for them. Your own bank will be a great starting point to discuss each of the different techniques and to consider their suitability for your own circumstances. Should you have any questions on the above, or if you would like any additional information, please do not hesitate to get in touch with Indie Mann or your usual contact at Scott-Moncrieff.