A short-term fix to offset the impact of a volatile currency

Until firms adjust to life under strong pound they will have to rely on hedging, writes Clifford German

The pound has fallen back about 5 per cent in the last 10 days since the Bank of England sent a signal that UK interest rates were now high enough to control inflation. The slide has come as a welcome relief to hard-pressed exporters who faced a serious struggle to compete if sterling remained at its recent high.

The impact of sustained strength could have been significant, costing companies between pounds 12bn and pounds 15bn in lost profits, it has been estimated. That would wipe out most if not all their expected profit gains this year, according to Douglas McWilliams, chief executive of the Centre for Economics and Business Research.

But currency analysts do not expect the relief to be permanent. UK interest rates are on average 2 per cent more than in the US, 4 per cent more than in Germany, and the UK economy still looks strong. With continuing economic growth and low inflation, sterling assets are an attractive home for foreigners' money.

Currency analysts who last month were predicting the pound would climb as high as 3.30 German marks, have revised their forecasts downwards, but many of them still expect to see DM3.15 early next year.

Economies have learned to live with strong currencies in the past, but it is a new experience for the UK and it could take two or three years and many redundancies before UK companies can achieve the extra productivity gains needed to offset sterling at its current levels.

In the meantime they must rely on hedging, the only short-term way to offset the adverse effects of a strong pound. Even that, however, is not a universal panacea for all companies. Those based in the UK but with overseas earnings suffer a translation effect when they convert them into sterling for accounting purposes, and translation losses are almost impossible to protect against.

The real benefit is for exporters, who suffer an extra transaction cost in the form of profit lost on export sales. These companies can offset some of the risks by hedging their commitments. This can take the form of selling the foreign currencies they expect to earn in future on the forward foreign exchange market, or by taking out a sterling call option on the options market, where specialist traders will tailor individual packages to meet the precise needs of the company.

On average over 90 per cent of all hedging deals and 80 per cent by value are done on the forward market, according to Nigel Rankin, head of the department at BZW that advises corporate customers. Selling currencies forward fixes the amount of sterling the exporter eventually receives, and rates are currently more favourable than spot rates.

But the contract has to be financed, the currency has to be delivered and if the pound weakens again before the sterling is due for delivery a forward contract can result in a loss.

Some of the biggest hedging deals of all are done on the options market, especially when currencies are fluctuating and rates could go either way. In such cases the exporter buys an option to convert set amounts in foreign currencies into sterling, normally at the current rate of exchange, say DM2.95 to the pound.

If the pound continues to strengthen to say DM3.20 by the time the exporter gets paid, he exercises the option and gets his money at DM2.95. If the pound falls back to say DM2.75 the option lapses and the exporter gets the benefit of getting the extra pounds in the normal way.

But nothing is for free, and buying an option incurs a fee rather like an insurance premium. The size of the fee varies with supply and demand, but a one-year option to sell marks for pounds at today's exchange rate currently costs about 4 per cent of the amount hedged. It can be cheaper if the exporter buys an option to trade at a less favourable rate, just as a motor insurance premium is cheaper if the driver pays the first slice of any claim.

Many big companies hedge about two thirds of their exposure to currency changes on their export earnings. But John Rennocks, the finance director of British Steel, made it crystal clear last week that there is no such thing as a permanent hedge against currency fluctuations.

Most hedges are designed to cover companies for around 12 months, and are often tailored to cover the company's financial year. Hedge transactions taken out before sterling began its spectacular rise a year ago have partially protected profits in the past 12 months, but many of those contracts have now expired, to be replaced by new ones at current, less favourable rates of exchange, and the impact of a strong pound on profits is likely to get worse before it gets better.

If sterling now stabilises around current levels some of the pain will disappear when next year's profits are compared with this, but the impact on competitiveness and remitted profits will remain It is extremely difficult to make long-term business plans against the background of the currency volatility which we have seen in the past year.

According to Mr Rennocks: " Hedging is an important part of any exporter's business activity, but it can only defer the impact of violent currency swings. What all exporters need is a stable exchange rate environment founded on a sensibly valued pound, not a wildly overvalued one."

It is, of course, possible that just as things look darkest, sterling will fall away as fast as it has risen and it will be importers rather than exporters whose profits suffer. There is no doubt that if EMU were abandoned or postponed in an orderly fashion the German mark would look much more attractive because the Bundesbank could then maintain its traditional commitment to holding down inflation in Germany without having to support traditionally more inflation-prone economies like Spain and Italy. But business cannot hold its breath.

FootballGerman sparks three goals in four minutes at favourite No 10 role
Rumer was diagnosed with bipolarity, attention deficit hyperactivity disorder and post-traumatic stress disorder: 'I was convinced it was a misdiagnosis'
peopleHer debut album caused her post-traumatic stress - how will she cope as she releases her third record?
A long jumper competes in the 80-to-84-year-old age division at the 2007 World Masters Championships
Radamel Falcao was forced to withdraw from the World Cup after undergoing surgery
premier leagueExclusive: Reds have agreement with Monaco
Arts and Entertainment
'New Tricks' star Dennis Waterman is departing from the show after he completes filming on two more episodes
tvHe is only remaining member of original cast
Life and Style
Walking tall: unlike some, Donatella Versace showed a strong and vibrant collection
fashionAlexander Fury on the staid Italian clothing industry
Arts and Entertainment
Gregory Porter learnt about his father’s voice at his funeral
ebooksAn unforgettable anthology of contemporary reportage
Arts and Entertainment
tvHighs and lows of the cast's careers since 2004
Life and Style
Children at the Leytonstone branch of the Homeless Children's Aid and Adoption Society tuck into their harvest festival gifts, in October 1936
food + drinkThe harvest festival is back, but forget cans of tuna and packets of instant mash
Lewis Hamilton will start the Singapore Grand Prix from pole, with Nico Rosberg second and Daniel Ricciardo third
F1... for floodlit Singapore Grand Prix
New Articles
Life and Style
Couples have been having sex less in 2014, according to a new survey
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating

By clicking 'Search' you
are agreeing to our
Terms of Use.

iJobs Job Widget
iJobs Money & Business

Senior BA - Motor and Home Insurance

£400 - £450 Per Day: Clearwater People Solutions Ltd: **URGENT CONTRACT ROLE**...

Market Risk & Control Manager

Up to £100k or £450p/d: Saxton Leigh: My client is a leading commodities tradi...

SQL Developer - Watford/NW London - £320 - £330 p/d - 6 months

£320 - £330 per day: Ashdown Group: The Ashdown Group have been engaged by a l...

Head of Audit

To £75,000 + Pension + Benefits + Bonus: Saxton Leigh: My client is looking f...

Day In a Page

Scottish referendum: The Yes vote was the love that dared speak its name, but it was not to be

Despite the result, this is the end of the status quo

Boyd Tonkin on the fall-out from the Scottish referendum
Manolo Blahnik: The high priest of heels talks flats, Englishness, and why he loves Mary Beard

Manolo Blahnik: Flats, Englishness, and Mary Beard

The shoe designer who has been dubbed 'the patron saint of the stiletto'
The Beatles biographer reveals exclusive original manuscripts of some of the best pop songs ever written

Scrambled eggs and LSD

Behind The Beatles' lyrics - thanks to Hunter Davis's original manuscript copies
'Normcore' fashion: Blending in is the new standing out in latest catwalk non-trend

'Normcore': Blending in is the new standing out

Just when fashion was in grave danger of running out of trends, it only went and invented the non-trend. Rebecca Gonsalves investigates
Dance’s new leading ladies fight back: How female vocalists are now writing their own hits

New leading ladies of dance fight back

How female vocalists are now writing their own hits
Mystery of the Ground Zero wedding photo

A shot in the dark

Mystery of the wedding photo from Ground Zero
His life, the universe and everything

His life, the universe and everything

New biography sheds light on comic genius of Douglas Adams
Save us from small screen superheroes

Save us from small screen superheroes

Shows like Agents of S.H.I.E.L.D are little more than marketing tools
Reach for the skies

Reach for the skies

From pools to football pitches, rooftop living is looking up
These are the 12 best hotel spas in the UK

12 best hotel spas in the UK

Some hotels go all out on facilities; others stand out for the sheer quality of treatments
These Iranian-controlled Shia militias used to specialise in killing American soldiers. Now they are fighting Isis, backed up by US airstrikes

Widespread fear of Isis is producing strange bedfellows

Iranian-controlled Shia militias that used to kill American soldiers are now fighting Isis, helped by US airstrikes
Topshop goes part Athena poster, part last spring Prada

Topshop goes part Athena poster, part last spring Prada

Shoppers don't come to Topshop for the unique
How to make a Lego masterpiece

How to make a Lego masterpiece

Toy breaks out of the nursery and heads for the gallery
Meet the ‘Endies’ – city dwellers who are too poor to have fun

Meet the ‘Endies’ – city dwellers who are too poor to have fun

Urbanites are cursed with an acronym pointing to Employed but No Disposable Income or Savings
Paisley’s decision to make peace with IRA enemies might remind the Arabs of Sadat

Ian Paisley’s decision to make peace with his IRA enemies

His Save Ulster from Sodomy campaign would surely have been supported by many a Sunni imam