Consulting » EXPORTING – FOREX – Are your hedges in shape?

Any UK exporters which thought the solution to their European currency exposure problem was merely a waiting game received a rude awakening on 28 September 2000, when the Danes voted to reject adoption of the euro.

The Danish no reaffirmed UK hostility to the single currency. A recent poll carried out by Accountancy Age magazine found that 40% of UK FDs were against the UK joining the euro in the lifetime of the next parliament.

One foreign exchange trader at a European bank in London said, “We are discounting any likelihood of Britain joining EMU for at least seven to eight years.”

So, even though the single currency seems to have survived the hammering it has taken since January 1999, exporters will have to cope with euro exposure for some time. “A number of corporates were working on the presumption that the UK would go into the euro on a three-year-or-so horizon,” says Neil Record, chairman of currency management specialist Record Treasury Management. “That horizon has slowly lengthened and the corporate view is now that it is no longer a question of time, and they will treat the euro as they do the dollar or the yen.”

Even if Britain did adopt the euro, currency management would still be necessary. “There’s still the rest of the world that the UK trades with, and exporters need to manage their exposure against the dollar, the yen, the Swiss franc, Far Eastern currencies, and so on,” says Dominic Bennett, principal consultant at KPMG Consulting. “Whether the UK is in or out of the single currency is not likely to have a huge effect on treasurers in their overall task of currency management.”

What is likely to have a significant effect on business is how adept corporates are at managing this risk. The costs of getting it wrong are there for all to see. Take, for instance, the case of Allied Lyons, which, in 1991, began speculating in currency options. In essence the company set up a speculative operation trading in foreign exchange instruments in the hope of making additional profits that had nothing to do with the underlying business. The losses caused by this gamble amounted to #147m.

Even more damaging were the corporate governance questions that were raised in the wake of the disaster: who authorised these operations, did the board know what was taking place and, if so, did they understand what they were doing?

Then, three years ago, there was Victrex, a plastics company with a #100m turnover. It was earning nearly all its revenue in foreign currencies, mainly dollars and Deutschmarks, so the rate at which it could buy or sell sterling was crucial. The company set up a budget with certain foreign exchange rate targets to meet or break. It calculated a rate of about $1.50 to the pound and put in place a policy based on a 12-month revenue forecast. It had to hedge 75% of its exposure for the first six months, scaling down the percentage for the second six-month period. The board assumed that the treasury was hedging properly, but the company got into a muddle when the dollar started to weaken.

Soon, it was no longer possible to put in hedges at $1.50 or better. But, instead of locking in, the treasurer stopped hedging. Meanwhile, the dollar continued to weaken and the board remained blissfully unaware that no hedges were being put in place. It made a year-end profit forecast on the basis that the company had hedged, and several directors exercised their share options on the bullish statement. Subsequently though, Victrex had to put out a profit warning when it realised it was not hedged, and the share price plummeted. The Stock Exchange and the DTI even launched a probe amid speculation that the company had created a false market in its own shares. The lesson is that a corporate treasury can start off with something quite trivial, such as setting out a budget exchange rate, only to find itself with its positions unhedged or locked into an unfavourable rate, with potentially dire consequences for the company and its FD.

There have been more than enough similar headline cases in recent years to serve as examples of how companies can get themselves into trouble by failing to hedge or by over-hedging. Alan Collins, global head of foreign exchange at JP Morgan, is confident that most corporates are now taking a more sophisticated approach towards the planning process. “Also, over the past five years or so, banks have gained awareness of the need to provide their corporate customers with suitable hedging advice,” he says.

“Often, exporters are not looking for an exchange rate level but rather a sense of stability to enable them to plan properly. The most important factor for a corporate is to have a strategy to avoid getting caught out by currency movements and to communicate that strategy to shareholders, so they are aware of the company’s approach to hedging.”

Risk management is crucial for an exporter. The company needs to establish if it is risk averse, or, on the other hand, whether it has a strong appetite for risk. “The question is whether it would like protection from major risks but still wants to give itself an opportunity to benefit if rates move in its favour,” says KPMG’s Bennett. “Most corporates cluster somewhere in the middle, where they want to protect themselves against most of the risks but not shut down all opportunities if rates move in their favour. This might be evidenced by having a policy of hedging 50% of a company’s forecast exposures.”

The fact is that anybody who is dealing in international markets has a foreign exchange risk, whether or not they proceed to hedge their foreign currency position. John Emmett, group managing director at private bank Leopold Joseph, says, “As we go round and talk to people it’s clear that a number of the smaller businesses are perhaps not as aware as they might be how they can protect themselves against exchange rate fluctuations. We’re trying to provide a service that enables them to strip this element of risk out of their business, or at least to reduce it.

“We’ve tried to set out a process whereby an initial margin is deposited against the foreign exchange trade with provision for it to be topped up if exchange rates move against the purchaser of the contract. Money may be released back to the customer if the exchange rates move in their favour. The companies we are dealing with would typically have someone who looks after the finance function, but normally they would not be people with any kind of sophisticated treasury. We’re trying to provide expertise to someone who comes from an accountancy background but without much experience in managing money.”

Leopold Joseph’s operations are dwarfed by huge currency dealers, such as Barclays and Royal Bank of Scotland. But the bank sees a competitive advantage in the service it offers, which is essentially a direct line from the corporate client to the dealing desk where prices are being made. “Given that the foreign exchange market is very volatile and things happen quickly, we think that’s a major advantage for customers,” says Emmett. “Our people are not brokers, but are actually making prices.”

The basic principle, he says, is to make the process easier for the bank and simpler for the customer with a facility that a corporate can take on a stand-alone basis without it impinging on other banking facilities. Behind that, Emmett says, it is important for a corporate to have access to advice on how to approach its particular circumstances, given the variety of means available for hedging in the foreign exchange markets.

Some corporates, including large-scale exporters such as UK confectionery manufacturer Mars, have complained about the rising cost of foreign exchange dealing over the past year. There have been charges of a dwindling number of banks running a cartel to widen the spread – the difference between buying and selling rates for currencies – on currency transactions for corporate customers. There is little evidence to support the cartel allegations, given the cut-throat nature of the foreign exchange markets and the fact that dealers hungry for business will happily trade inside a spread to shave a point or two off the rate to win the deal. But corporates do need to be aware of who is providing them with basic hedging and expensive currency options services. When a bank sets out to offer advice to a corporate customer it is in fact trying to sell its products. Generally speaking, its advice is not independent.

There is a lot more to currency risk than simple foreign exchange contracts and, as KPMG’s Bennett points out, the first pitfall is to fail to accurately identify those currency risks. “A lot of companies are not very good at doing this,” he says. “It’s important to know what it is you’re trying to hedge. Take the example of a UK company with manufacturing locations in several countries, and with each of those facilities also exporting.

In this case, you find that you have a number of base currencies and a number of exposure currencies. Being able to identify on a group level what the net exposures are in each currency is a complicated exercise that a lot of companies don’t do. What you clearly want to avoid is buying and selling in the same currency, because you’re obviously doing more foreign exchange deals than needed, while incurring the bid/ask margin on the exchange rates, plus a lot of extra administration.”

Bennett explains that the first thing a company that wants to manage its foreign exchange needs to do is identify the net exposure in each currency across the whole of the group worldwide. “A surprising number of corporates don’t do that, but hedge on an ad hoc basis, so one minute they’re buying dollars and the next they’re selling dollars, instead of trying to find out their net dollar position and hedge that,” he says.

Most practitioners argue that exporting corporates need systematic currency risk management that doesn’t take into account the corporate treasurer’s personal views on the subject. For example, treasurers are very reluctant to have protection for periods as long as 12 months – their average hedge horizon would be two to three months.

“There are in-built prejudices,” says Record. “Many treasurers believed the euro was going to be strong against the pound and this tilted their decision-making on hedging, in that they would not have wanted to take out too much hedging. Hence, for many corporates there was very little hedging.”

Exporters also need to understand and accept the interplay between currency movements and a country’s economic performance. Economic trends ultimately affect exchange rates, a fact which KPMG’s Bennett points out is not very well understood.

“What is not generally recognised, but is pretty obvious, is that there is a strong link between the strength of an economy and the strength of a currency,” he says. “If you look at long-term trends, the closest link between the way a currency performs against another currency can be seen in that country’s inflation rate. If you have higher inflation than another country you can expect your currency to devalue over the course of time to maintain purchasing power. There is almost an exact correlation over the long term between differentials in inflation rates and the way currencies move,” he says.

“Look at Germany against Britain over the past 30 years. Germany had much lower inflation than the UK and sterling declined quite steadily against the Deutschmark over that period of time. What that really boils down to is that, if you can have a strong economy you’ve got to accept that you’re going to have a strong currency as well.”