Living on the hedge

Fluctuating exchange rates have been a problem for UK exporters for decades. Hedging is one strategy for minimising their impact, but as Maria Kielmas reports, its results can be just as unpredictable

Foreign exchange risk and British manufacturing have always been an uneasy coupling. When sterling was weak in the 1970s and 1980s company managers complained about the cost of their imported raw materials. Today, sterling’s strength against the euro is, for many manufacturers, the main stumbling block to maintaining market share in the eurozone.

Since the 1970s financial services providers have been inventing tools to handle fluctuations in exchange rates, interest rates and commodity prices under the generic name of financial risk management or hedging. So if British manufacturers have been so badly stung by the slump in the euro, have their risk managers failed in their duties?

Stuart Robinson, senior UK economist at Lombard Street Research, says: `In 1996 when sterling first began to appreciate against the deutschmark some companies did say that they would not be affected because they had protected themselves.’ But as sterling’s level rose to new highs earlier this year, the currency risk faced by these companies began to change.

`At this point it becomes part of a wider business strategy, such as where you source your supplies,’ says Keith Darlington, director of treasury operations at chemicals and pharmaceuticals group AstraZeneca. `Financial instruments can protect you from short-term volatility but in the long term you have to be competitive.’ That means moving production or moving suppliers.

Foreign exchange risk in working capital is hedged for a period of one to three months using forward exchange contracts (see box). This form of hedging is appropriate for working capital – money in the pipeline arising from a signed contract which is certain to materialise.

Forecast transactions are hedged 12 months ahead within authorised limits using a mixture of currency options and forward contracts. `Here we are looking at forecast cash flow and it’s more appropriate to use options hedging. The maximum loss is the premium you pay,’ says Darlington.

But that premium can be a hefty sum for a small company. On average, companies can pay a premium of 10% on their maximum exposure.

Neither currency hedging nor commodity price hedging have ever been a universally popular undertaking because of its easy come, easy go reputation for profits and losses. The collapse in 1996-97 of the US-based hedge fund Long Term Capital Management (half of whose partners held doctorates in finance and two had won Nobel prizes in economics) prompted worldwide accusations that financial risk management does not work. Multinational companies, such as Sweden’s Electrolux, suffered damaging publicity as a result of losses from unauthorised foreign exchange trading – so-called rogue trading – which it was obliged to announce in December last year.

And for smaller companies, the options are limited. The smaller company does not have the multinational’s option of equalising currency losses through geographical diversification, or ensuring the value of components bought in one currency area match sales in that area. It must make strategic decisions to cope with currency volatility, especially between sterling and the European currencies, rather than depend on financial instruments.

Rilton Electronics, in Crowborough, East Sussex, has a greater exposure to the US than to Europe but exchange rates between the Dutch guilder and sterling have been a major problem for nearly 30 years. Managing director Doug Kent sums it up: `You never know where you are. There have been so many devaluations between the European currencies there was no way you could hedge and make money at the same time unless you had prior notice of the devaluation.’

Finance directors – look away now

If you’re not a finance whizz, here’s a 60-second briefing on the world of spots, options, strikes and suchlike…

Basically, foreign exchange risk is the exposure of a company’s finances to the potential impact of movements in foreign exchange rates. Managing foreign exchange risk, or hedging, attempts to control the impact. Here’s how:

Spot contract: the simplest foreign exchange transaction. One currency is exchanged for another at an agreed rate for settlement two business days later. The majority of foreign exchange transactions are carried out this way.

Forward contract: essentially the same as a spot contract but deferred for a period in the future. It is a foreign exchange deal done at today’s date for payment or receipt at a later date, usually between one and 12 months, with the exchange rate locked at the date of the deal.

Foreign currency option: a contract where the buyer purchases the right, but not the obligation, to buy or sell a specified currency at a predetermined exchange rate (the strike price) on or before a future date. It not only protects the buyer against unfavourable movements in the exchange rate, but also allows him or her to take advantage of favourable ones, in return for a single upfront premium. The premium depends on the period of cover, market volatility and the strike price. If the buyer chooses a slightly riskier strike price than market sentiment predicts, the premium can go down dramatically.