Implications of Brexit and managing currency risk

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John Finn, Managing Director of Treasury Solutions, answers some key questions related to management of currency risk.

Will my bank permit me to hedge my foreign currency exposures?

For an exporter to hedge its currency risk, in the first instance, it must first have a foreign exchange line of credit from the bank. This must be formally sought in advance prior to its use and, from the bank’s perspective, it is the equivalent of making a loan application ie it requires credit approval.

What instruments will the bank permit me to use in order to manage foreign currency risk?

For the most part, this is restricted to either spot or forward transactions. The former implies selling sterling at the current market rate.

As a general rule, spot deals settle in two days’ time ie agree a rate on Monday with funds transferring on Wednesday. In the case of forward foreign exchange contracts, a rate can be agreed today to apply to receipts on a future date.

The advantage of this instrument is that an exporter can bring certainty to the amount of euro that it will receive in return for a specified amount of sterling at this stated future date.

The primary disadvantage is that there is no opportunity to share in any upside in any currency movement.

In order to achieve that objective, it is possible to purchase an instrument known as a foreign exchange option. However caution is urged; it is an extremely useful instrument to utilise in managing foreign exchange risk, but it needs to be constructed appropriately. In essence, it is an insurance product for which the purchaser pays a premium and which protects it against a worst possible (defined) outcome whilst permitting full participation in the upside should it arise.

Some banks sell a combination of an option and forward contract called a participating forward. This allows participation in a fixed percentage of the upside. However it does have a cost. Again, these should not be purchased without full knowledge and understanding of what is involved.

How far forward can I hedge?

Most banks will have a maximum time period for which they will sell forward contracts to their customers. This needs to be ascertained now. In general, most banks will not provide forward contracts for periods beyond 12 months.

What terms and conditions apply?

In some cases, the banks may require security to be provided in the form of charges over assets or guarantees. If the exporter is already a borrower, it is probable that the bank would simply extend any security that it already had over the foreign exchange line. It may also monitor the extent to which the currency contracts are showing a “profit” or “loss” at a point in time and either limit this or seek some collateral, which may include cash, if the loss – although only theoretical – extends beyond the defined amount.

Finally, some banks may require the completion of what is known as an ISDA agreement. This is quite a complex document to complete for the first time, and proper advice should be taken in its construction and prior to signing it.

One final point to note in hedging foreign currency risk is that there are non-bank providers of such services who tend to be less prescriptive in their dealings. However, many borrowing agreements now specify that the borrower may only conduct foreign currency transactions with the lender.

What are the wider financial implications associated with currency risk?

The obvious effect of weakening sterling is adverse consequences for both profitability and cash flow. Immediate actions that could be taken include:

·         Calculation of the exchange rate at which UK sales are no longer profitable

·         Rerunning financial forecasts at current exchange rates and assessing the projected outcomes

·         Where financial covenants are part of your borrowing agreement, ensure that adverse foreign exchange moves do not materially and negatively impact on compliance with them

Please note that where companies with material amounts of UK exports intend to refinance their banking facilities in the coming months, a significant amount of sensitivity analysis will be required in any financial projections provided to banks.

I would strongly urge paying close attention to the terms and conditions attaching to any new borrowing agreements, as I would expect banks to tighten up significantly in this area as a consequence of the UK vote to exit the European Union.

 

For Irish companies exporting to the UK, the Enterprise Ireland Currency Risk Calculator can help you understand the impact of movements in the sterling/euro exchange rate on your business.