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How UK exporters can better manage their FX risks

By Daniel Kinnear, Associate Director of Corporate Risk Management, Barclays Capital

June 2007


Currency markets have become more volatile


UK exporters are becoming increasingly focused on foreign exchange (FX) and have benefited from increased competition between their FX providers.  This has manifested itself not only in tighter bid/offer spreads but also in greater product innovation. 


In calm currency markets, tighter spreads have provided exporters with the means to slightly improve margins.  This was probably best illustrated during 2001-2002 when sterling-dollar (GBPUSD) traded tightly within a 1.40 to 1.50 range and 12-month volatility fell to, what was then, a historical low of 7.0%.


During the past five years, however, the sterling-dollar exchange rate has witnessed heightened volatility, with 12-month volatility rising to a historical high of 10.0%.  Unfortunately, to the detriment of UK exporters receiving US Dollar income, this volatility drove sterling-dollar in one direction, upwards through the 1.50s to an eventual twenty five year high of 2.0137 in January 2007.


As sterling-dollar has appreciated, UK exports of a number of goods and services have become comparatively more expensive.  In many instances this has fed through to downward pressure on gross margins as the sterling-value proceeds of currency receivables is reduced.


Recognising the limitations of traditional hedging techniques, UK exporters have begun to question how they approach foreign exchange risk management.  An overriding theme that has emerged during the past two years has been the desire to minimise risk but not opportunity.  Reducing risk, whilst securing and enhancing profitability has become the modern mantra.


What do these movements mean for UK exporters?


For UK exporters foreign exchange movements such as these not only present significant risk but also significant opportunity.


The extent of this is most acutely recognised when a sterling-value is attached to a one cent movement in the GBPUSD exchange rate per unit of US dollar-income.  For example, a common metric that we use to illustrate the value at stake is “a one cent movement per $1,000,000 of US dollar receivables, leads to either £3,000 of margin enhancement or erosion”, depending upon the direction of the movement, as illustrated in Figure 1 below.


Figure 1:  Historical GBPUSD closing rates (source: Reuters, 4th June 07)





Figure 1 reveals how sterling-dollar has trended during the past three years, with the daily closing spot rate moving both up and down.  Of particular interest is the extent of the upward and downward movements witnessed over relevantly short periods of time.  Focusing on those illustrated by the red (unfavourable) and green (favourable) arrows, it is evident that sizeable rate gains or losses are possible.


Example


An exporter with $20,000,000 of USD-income will have gross margins impacted by £64,000 for each single cent movement in the exchange rate.  Average movements of up to 20 cents are not uncommon.  This would lead to value enhancement or erosion for the exporter of almost £1,300,000.


Contrasting such risks against one’s overall profitability will address the question of whether foreign exchange risk is material and in need of management.  Irrespective of the magnitude, however, a small amount of time invested in updating oneself with the latest risk management approaches can lead to a more optimal financing strategy.


In recognition of the increasing focus that many exporters are giving foreign exchange risk management, this article seeks to share some insights into the motivations behind the various hedging decisions that are made.


Protection versus Participation


The two most common approaches to foreign exchange risk management are centred on an exporter’s desire to:


  • Participate - Simply transact foreign exchange at “Spot” as and when required; or
  • Protect - Fix “Forward” into a guaranteed rate for future delivery to gain certainty. 


Both approaches have their merits, and in the right market environment can prove to be the most optimal.  They also, however, can prove disastrous, as Figure 2 below and the following section highlights.


Figure 2:  The three P’s of FX risk management (source: Barclays Capital)


 

Transacting at Spot


Rather than fix into the historic high, many exporters may be tempted to wait and see where rates progress to.  By waiting (i.e., doing nothing today), the exporter retains total flexibility and benefits fully in any favourable rate movement were it to subsequently occur.  On the matrix above this ascribes to them a “High” rating for Participation.


Doing nothing, however, exposes the exporter to the very real risk that if rates move in an unfavourable direction value would be destroyed.  It is because of this total lack of protection that the do nothing approach warrants a “Low” rating for Protection.


This strategy proves most optimal for exporters in a falling market (as illustrated by the green arrows in Figure 1), where the sterling-value proceeds of any US income increases as the GBPUSD falls.  Conversely, it will lead to reduced sterling proceeds if rates rise (red arrows)


Transacting via Forward Contract (Low Participation / High Protection)


Fixing forward, in contrast, presents the complete opposite balance of protection and participation.  Primarily that by entering into a contractual agreement the exporter obtains “High” Protection, but also suffers a total prohibition on Participation, or in the terms of the framework “Low” Participation.


With forward contracts being the most common hedging instrument used by UK exporters, it is interesting to explore in slightly greater detail the key advantages and disadvantages of the instrument. 


Advantages

  • Provides fixed rate certainty that enables exporters to financially manage their businesses.
  • Like purchasing at spot, the cost of the solution is in the rate, no premium payment is required.


Disadvantages

  • No ability to benefit from favourable rate movements.
  • Limited ability to restructure the hedge (either in terms of tenor or amount) should market views or business needs change.
  • Due to the obligation to transact at the forward rate, exporters will require a credit line from their foreign currency provider.  For credit constrained exporters, which are unable to obtain sufficient facilities, cash cover may be required.


The High Protection / High Participation Solution – Vanilla Options


Given the disadvantages of both methods it is unsurprising that many exporters have sought solutions that provide both total protection and full participation.


Traditionally, Vanilla Options have satisfied this need by providing their owner with the right to transact at a predefined rate.  Since this is a right and not an obligation, if rates prove to be more advantageous, the holder of the option can elect not to use it and instead transact at the more attractive rate.


Due to the fact that this solution provides both “High” Protection and “High” Participation, and does not expose its holder to any inherent risk-return disadvantages, a Premium payment is required to re-balance the Premium-Protection-Participation equation.


For many exporters the premium payable may be deemed too expensive, however, for a few where uncertainty of the currency cash flow is an issue, the flexibility provided by the option may be viewed as worth the expense.

How can we better balance the three Ps - Premium, Protection and Participation?


The three approaches discussed above can each prove to deliver significant value to exporters if used in the right market conditions. 


Ideally, an exporter would wish to fix forward in rising rate environments and remain at spot when rates are falling.  Since both of these solutions can be had for zero premium, they deliver the most cost effective hedging strategy.  Unfortunately, however, knowing when to fix forward and when instead to do nothing and transact at spot is very difficult.  Furthermore, with purchased options more often than not being viewed as too expensive, this ideal solution is often not even considered.


Recognising the dilemma posed by the desire for both participation and protection at zero cost, banks such as Barclays have developed a range of structured solutions that seek to better balance the three Ps of premium, protection and participation.


Starting with the zero premium constraint, it is now possible for exporters to obtain solutions that strive to offer a more dynamic balance of protection and participation. 


Figure 3:  The three P’s of FX risk management (source: Barclays Capital)


 

Figure 3 above shows the Efficient Zero Premium Frontier joining both the forward and spot approaches.  Structured solutions enable exporters to position themselves anywhere along this line, thereby obtaining a solution that better meets their requirement for both protection and participation.  In essence, a solution that not only protects margin but also provides them with the opportunity to enhance profitability.


Given the pressures on businesses to deliver ever increasing returns to shareholders, finding the most optimal hedging solution is an important role for any finance manager.  Adoption of a measured approach to foreign exchange risk management that ensures that margins are protected and that does not limit the opportunity for margin improvement can help achieve this goal.


 

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