27 December 2017
Brexit: Hedge against exchange rate risks
The continuing uncertainty surrounding the precise terms of Brexit is causing serious blows to the pound sterling. Although hedging against exchange rate risks is perfectly possible, only a minority of SMEs take the step. These are the options and cases where hedging should be considered.
The United Kingdom has never been part of the eurozone, so as an exporter you have always had to take the pound exchange rate against the euro into account in your cost price calculations. However, as a result of the Brexit turmoil, the currency has become a lot more volatile. Negotiate contracts in euros with your customers in the UK whenever possible. Or try to include an exchange rate clause in your contracts to make sure price adjustments are an option. If this does not work, consider whether you should protect yourself against exchange rate risks.
This is how you could hedge the risk
Fortunately, there are a lot of instruments in place to protect you against price falls. The most frequently used is the forward contract. This simple method works as follows:
- Suppose you receive your payment in pounds in three months' time, you can conclude an agreement with your bank in which you sell a certain amount of pounds on a specific date at a certain price.
- The price in the forward contract is determined on the basis of the spot price and swap points, being the interest rate difference between the pound and the euro at the time you conclude the forward contract.
- On the due date, you will sell the pounds you receive at the forward rate specified in the forward contract, regardless of the exchange rate of the pound at that time. The advantage: you do not have to worry about a falling pound price between the date of hedging and the time of payment. The other side of the coin is that with a forward contract you will not be able to benefit from a possible upsurge of the pound during the same period.
The forward contract is the most common instrument to hedge against exchange rate risks, but certainly not the only one. Your banker can offer you the best solution in your specific situation.
Hedging or win some, lose some
Is hedging against exchange rate risks really a must for every exporter who is trading with the UK today? The answer is no. In fact: some companies are very consciously adopting the 'win some, lose some' strategy. Take the following factors into account when you decide:
The size of your profit margin
Profit margins are very industry-dependent If you work with a very small profit margin, though, your profit may disappear in a blink of the eye when the exchange rate drops by 5 or 10%. But if, for example, your margin is around 30%, you can easily cope with a fluctuation of that magnitude.
The size of your turnover in pounds
How many currencies present a risk for you? And what is the share of your turnover in pounds in proportion to your overall sales? The larger the share, the more a price fall will affect you. Or, the better you will need to hedge to protect yourself.
The term of your quotation phase
If there is usually a lot of time between your quotation and the signing of the contract, you are exposed to exchange rate risks for a long time. Moreover, during the quotation phase you should not be hedged by a forward contract. Because you will be committed by it, even if the deal your customer does not go ahead. In that case, the best thing to do is take an option. This will protect you - subject to payment of a premium - against an unfavourable price evolution, but you retain the right to waive the hedge if the contract does not go ahead.
The payment terms
Do your customers get generous payment periods or do you sometimes allow them to postpone payment? In that case your company will also be exposed much longer to possible price fluctuations than if the time span is very short.
The duration of the contract
If you conclude long-term contracts, you should definitely seek the advice of your bank. In the case of long-term purchase contracts a different exchange rate strategy is required for certain and potential purchases. For example, partial hedging may be worth considering.
The strategy of your competitors
Suppose, you hedge your risks, but your competitors don't. Your competitor will benefit from a strengthening of the pound during the term of your forward contract. In the event of a weakening of the currency, on the other hand, you will have a competitive advantage.
Ask your bank
If you have a significant turnover in pounds and you are exposed to price fluctuations for a long period of time, do not hesitate to involve your banker in time. He will work with you to make a customised analysis of your situation and calculate the difference between a contract in euros and a hedged contract in pounds. For example, you could create a buffer for possible price falls and the profitability of your exports to the UK will not be eroded as a result of a falling exchange rate.
Want to know more?
Do you have any more questions about the consequences of Brexit or do you want to know which solution suits your company?