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
Wednesday 13 August 1997
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.
- 1 Apple has installed security backdoors on 600m iPhones and iPads, claims security researcher
- 2 UK pirates will get four warning letters a year
- 3 Fight Club 2: Chuck Palahniuk sequel is a 'meta-fictional comment on the cultural response to the original'
- 4 Is Gideon Levy the most hated man in Israel or just the most heroic?
- 5 Israel-Gaza conflict: Deadly flechette shells 'used by Israeli military in Gaza Strip’
Hacking Trial: Rebekah Brooks, Raisa and a new twist in the saga of a horse fit for a Prime Minister
Israel-Gaza conflict: Palestinian death toll now exceeds 500 – but Israel fights on
Income tax league: Revealed - the UK towns where people pay the most and least tax
Israel-Gaza conflict: Deadly flechette shells 'used by Israeli military in Gaza Strip’
Malaysia Airlines MH17 crash: Blogger captures footage ‘showing BUK missile launcher that shot down jet’ now back in Russia
Malaysia Airlines flight MH17 crash: 'Nine Britons, 23 Americans and 80 children' feared dead after Boeing passenger jet is 'shot down' near Ukraine-Russia border
Malaysia Airlines MH17 crash: Vladimir Putin is given 'one last chance' to end hostilities in Ukraine
The 'scroungers’ fight back: The welfare claimants battling to alter stereotypes
The truth about conspiracy theories is that some require considering
Malaysia Airlines MH17 crash: Ukrainian military jet was flying close to passenger plane before it was shot down, says Russian officer
Malaysia Airlines MH17 crash: victims’ bodies bundled in black bags and loaded onto trains
iJobs Money & Business
£850 - £950 per day: Orgtel: Programme Director - Conduct Risk - Banking - £85...
£45000 - £50000 Per Annum + excellent benefits: Clearwater People Solutions Lt...
£250 - £300 per day + competitive: Orgtel: Finance Manager - Accountant - Bank...
£100000 - £120000 per annum + BONUS + BENEFITS: Harrington Starr: A leading fi...