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Currency protection
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How to get protection against currency moves
International transactions will inevitably carry a significant exchange rate risk if the settlement takes place at some point in the future and these risks exist for both individuals and companies. Examples include:
The purchase or sale of an overseas property.
The buying of any large asset overseas including cars and boats
Corporate buying of overseas machinery or raw materials.
The buying or selling of overseas companies
The nature of the risk involved can be examined in the following example.
Example A UK resident is looking for overseas property in Spain. A contract is signed on a property on March 1st for completion on June 1st.
After agreeing to pay a 10% deposit, there is a final balance of EUR200,000 due on June 1st. The Sterling Euro exchange rate on March 1st is 1.4650 and the Sterling cost on March 1st is, therefore, £136,519.
During March and April and May, Sterling weakens against the Euro to reach 1.4450 by June 1st. The Sterling cost is now £138,408, an increase of close to £2,000. If Sterling suffered a steeper fall to 1.42 against the Euro, the extra cost would be over £4,300.
The situation could of course move in the other direction as any weakening of the Euro would provide a windfall gain for customers in Sterling terms.
To some extent, it is therefore a gamble, but buyers need to consider the risks carefully, especially as there could be important budget consequences. In particular, if there would be serious consequences in suffering costs above the budget level, a forward contract will need to be considered very carefully.
What can you do about it?
If the risks of adverse currency shifts are deemed too high, customers can take out protection in the form of a forward contract.
How does it work?
In the example above, the customer can take out a forward contract on March 1. There would be an agreement to buy 200,000 euros for June 1st.
The forward price of the contract is derived from the difference in interest rates between the two currencies. If for example interest rates were at 2.0% in both Spain (Euro-zone) and the UK, there would only be a small transaction cost involved.
If UK interest rate are higher, there will be a higher cost for the forward contract. If, for example, UK interest rates are at 4.75%, there would be an additional cost of taking out a forward contract. In this case, the 3-month forward price is 1.4550. The total cost will, therefore, be £137,457, compared with the GBP 136,519 spot price, but the customer is completely safe from any exchange rate shifts during the three-month period.
What is the downside?.
The exchange rate could move in the customer’s favour and there will, therefore be an opportunity cost involved.
The situation is different where interest rates in the target country are higher than in the UK.
If for example, the property is being bought in Australia for AUD300,000 and Australian interest rate are at 5.5% while UK rates are at 4.75% the forward price of the contract is AUD299438, a saving on the spot rate of £562.
Commercial transactions
The position is similar for commercial transactions. If a UK company has agreed to take delivery of equipment/parts with payment and delivery due in three months time, there will also be an exchange rate risk.
The company can use forward contracts in a similar way to secure protection. The situation is particularly important for imported components as the costs will have an important impact on profit margins.
For example:
A company agrees to buy raw materials from the US on March 1 for delivery and payment on June 1st. The agreed price is $300,000.
The current spot rate for the Sterling/dollar exchange rate is 1.8850 and the Sterling cost on March 1st is therefore GBP159,151.
If by June 1st Sterling has fallen to 1.80 against the US dollar, the actual cost will be GBP166,667, an increase in the Sterling cost of £7516 which could have serious consequences for profitability.
The company can, therefore, take out a forward contract for the US$300,000 on March 1.
With US interest rates at 3.0% and UK interest rates at 4.75%, the 3-month forward rate will be 1.8768.
The Sterling cost for the contract will, therefore, be 159,847. This is an additional cost of close to GBP700, but the company has complete security over the cost involved.
Again, if interest rates are higher in the country where the raw materials are being imported from, there will be savings by taking out a forward contract.
At the present time, for example, there would be forward-contract savings when dealing with costs invoiced in Australian and New Zealand dollars.
What is the downside?
Again, in the example above, if Sterling strengthens against the dollar, there will be an opportunity cost involved by taking out the forward contract. The company needs to consider the risks involved in hot taking out protection and the risks whether Sterling will strengthen or weaken during the relevant period
What are the alternatives?
Companies could try to aim to secure a Sterling price for the raw materials and shift the currency risk on to the supplier.
Companies could also try to source from within the UK, if this is cheaper. If the cost savings from sourcing overseas are substantial, however, it will be cheaper to source from overseas and take out currency protection.