Navigating the currency markets

HISTORICALLY, importers and exporters have had limited choice when it comes to dealing with foreign exchange (FX).

For many companies, especially new businesses, the focus is sales and cash flow, while FX is seen either as an unwelcome cost or a fortuitous windfall.

In the 1990s, many companies took a fly-by-night approach to the risk, choosing to settle invoices in foreign currency at the last possible moment or to convert incoming currency on arrival.

Even forward hedging was seen by many as a confusing complication; companies chose to deal with the FX hand they were dealt.

Fast-forward 15 or 20 years and the market is barely recognisable.

The UK is one of the most FX-savvy commercial markets amongst developed economies.

Currency forwards are seen as a standardised approach to managing risk, and SMEs are aware of an array of other products available to help them navigate the currency markets.

John Mullens is a corporate dealer at Global Reach Partners, which specialises in tailored foreign exchange solutions and hedging strategies to the corporate and private sectors.

He explains how the dynamic of foreign exchange has shifted over the years.

“Attitudes to risk have certainly changed,” he said.

“Companies now see foreign exchange as a threat and an opportunity, not just an external factor over which no influence can be wielded.

“Shareholders in turn are more demanding over policy when it comes to foreign exchange; they don’t like to see foreign exchange losses in the year-end accounts.

“There is no need for companies to hedge below their budgeted rates when they have access to a range of products that can help them avoid this.”

Between 2012 and the turn of 2015, the British pound broadly traded within a twelve cent range against the euro and a similar range in percentage terms against its other main counterpart, the US dollar.

January 2015 brought changes as the Swiss franc jumped 30% against the euro in a five minute time frame, the rouble dropped massively against the dollar, and commodity currencies started to weaken dramatically as the “China effect” cooled.

There has also been a growth in divergence in central bank policy, with the UK and US moving towards an imminent rate rise.

Europe and Japan are looking at additional stimulus and the emerging economies are drastically cutting rates.

The issue this creates for companies is one of market timing; hedging at the wrong time can lead to unnecessary losses.

The landscape of FX hedging and risk management has become a growing concern for businesses.

As forward contracts have become standardised, it is important to remember exactly what they are.

“Forward contracts allow firms to mitigate risk by fixing the rate of exchange on a deliverable amount of currency for a specific date in the future,” said Mr Mullens.

“At first glance they sound perfect and in many ways they are.

“Companies need a product that protects margins and offers a greater degree of certainty over future trade.

“The downside with forward contracts is that they do not offer any price flexibility.

“The fixed rate means that firms cannot participate in favourable market movement once the contract is agreed.

“For some people, forwards in themselves suffice and the flexibility on timing is all that is needed.”

In an ideal world, a hedging product should enable businesses to protect the exchange rate, offer price flexibility, and come at no cost to the buyer.

Where a forward contract can afford price protection, a “vanilla” FX option builds on this to provide that same flexibility, but at a cost, which is the premium.

The range of structured FX options available and the bespoke nature of these products means that a business’s appetite for risk can be matched precisely to the product.

While some options can offer full protection and limited upside gain, the riskier end of the scale offers significant upside potential, but in some circumstances can be matched with a scenario that gives no cover at all.

Structured FX options are not a new creation, as they have been used on a mainly institutional basis for some time.

Their availability to SMEs, however, is a fairly recent development.

An awareness of the financial products on offer, along with more in-depth strategic planning is likely to see firms of all sizes acting with greater versatility in how they hedge and the products they use.

This should enable businesses to remain competitive in the global marketplace due to flexible prices, but also to have the assurance measures are in place to protect against downside market risk.

The way companies manage the currency risks of overseas trade is evolving.

As sophistication amongst SMEs grows, so do the ways in which they meet this ongoing challenge.

To speak to one of the currency experts at Global Reach Partners please call 0203 465 8226 or email rhallahan@globalreach-partners.com