The foreign exchange hedging landscape has changed drastically over the last 5 years, says Joe Wass, Head of FX Strategy at Caxton FX.
“As volatility in the FX markets has increased, companies have moved further away from static ‘set-and-forget’ hedging portfolios and look to implement different types of FX hedging outside of Forward contracts.”
Businesses with an exposure to foreign currencies are in turn exploring more flexible hedging strategies to help navigate periods of greater uncertainty and minimize negative impact on their bottom line.
“At Caxton, over the last 3 years we have seen a significant increase in clients looking to develop fluid hedging strategies and introduce FX Options and structured products into their currency management”, adds Joe. This increase is also noted by The Bank of England, which reported a 15% rise in Options turnover between April and October 2018.
Corporates may explore other forms of FX hedging during times of political and economic instability, as spot and forward cover may not allow them to reach their budget rates. Having failed to lock in hedges prior to the recent drop in sterling, businesses may move to alternatives to help protect profit margins.
“A lot of corporates thought there would be a significant recovery in the pound through 2018 and 2019 and in turn, waited to hedge their currency exposures. That recovery hasn’t materialised and with GBP trading close to multi-year lows vs the US dollar and euro, Treasurers are now looking for alternatives to meet their objectives,” says Joe. This anticipated recovery may stall further over the coming months, as Brexit continues to dominate the outlook for the pound.
Despite the recent prorogation, or suspension, of Parliament, until mid-October, MPs succeeded in passing legislation aimed at preventing a no-deal Brexit. However, government compliance with the Bill is not guaranteed, hence a ‘hard’ exit remains on the table.
“Even with the Bill passing, the Government now has no majority, making the holding of a general election a question of when, rather than if. Whatever happens next; an election, no-deal Brexit, or a further extension, sterling will likely come under downward pressure as the political melodrama plays out and until the outlook becomes clearer”, comments Michael Brown, Senior Market Analyst at Caxton FX.
But the situation in the UK isn’t the only thing that plays a heavy part on the foreign exchange markets. ‘”Away from the UK, ongoing, and escalating, US-China trade tensions will be in focus, with tariff impositions now beginning to dent global growth as business investment slows. This slowdown in growth will likely result in monetary policy easing from global central banks, including both the Fed and ECB, however a significant degree of accommodation has already been priced in” adds Michael.
Rehan Ansari, Head of Risk Management & Derivatives at Caxton FX, says that companies may endure long term or ongoing exposure to adverse currency movements affecting future profitability especially during market trends that are one-sided. Companies that have a large foreign currency exposure due to a global presence like airlines or travel companies are a prime example, as they operate in an industry with variable overseas costs.
“In the current environment, companies may opt for an active hedging strategy that enables them to protect and participate. Put more clearly, protect their exposure from adverse market movements while allowing themselves to participate in favourable market conditions. The enhanced return may help businesses to remain competitive within their market as they will be able to offer clients better pricing, or it could be used to offset rising costs.”
So how should businesses look to mitigate currency risk?
“It all starts with a business defining its objectives based on currency risk exposure and cash flow requirements to cover operational costs and invoice payments over a set period of time,’ says Joe. Decide a hedging ratio that’s appropriate for the risk appetite of the business and review your timings to help decide what the best hedging approach should be. Once you have implemented the hedges, companies like Caxton will help you review the portfolio on an ongoing basis.
“Always check the FCA register to ensure that you are dealing with reputable companies that are not only well-known in the industry but are both Authorised and Regulated by the FCA”, recommends Rehan. “Making sure that your money is held separate from the day-to-day running of the business also ensures that your funds are safe in the event of the provider collapsing.”
With so much economic and political uncertainty both in the UK and internationally right now, businesses exposed to foreign currencies that are not hedging are taking a very big risk. Helping businesses every step of the way to protect their bottom line through Brexit and beyond is what we do best at Caxton FX.