Post Brexit: Managing FX Risks in Three Steps

by Dipak Khot, Head of FX Solutions EMEA and, Gareth Lloyd-Williams, Head of UK Corporate Sales, HSBC

The result of the UK’s recent Brexit referendum was a shock to many, despite polls predicting a knife-edge result. The result itself was a surprise but the market events which unfolded once the ‘leave’ vote was announced revealed some of the most experienced risk management professionals were unhedged against a weaker GBP or out of the money on long GBP exposures. This stark example of event risk has emphasised the importance of a strategic hedging programme rather than a reactionary approach and should prompt many companies to re-assess their existing treasury policies and risk management approach.

HSBC has many years of experience in following the world’s most significant risk events, and a wealth of expertise. The bank is proactive in working with customers to define and implement hedging programmes which combine stability and dynamism to reflect changing market conditions.

Treasurers need to have a hedging programme consistent with their internal treasury policy and such policy in turn has to match the underlying business requirement, this varies from sector to sector or from company to company depending on global exposure.

Step One. Hedge ratios and time horizon

Having defined the hedging objectives, the next step treasurers need to decide is the hedging ratio (i.e., what proportion of exposures to hedge) appropriate for their industry, shareholders’ risk appetite, and the risk management horizon. For instance, a heavy engineering company typically hedges over one to ten years, while a retailer may have a risk management horizon extending from one to six months. Inevitably, the time ‘buckets’ will be quite different in each case, as will the hedge ratio in each ‘bucket’, with most companies choosing to decrease the level of hedging over time depending on the reliability of forecast exposures. For example, a company may choose to hedge 100% of exposures during the following month or quarter, but only 10 or 20% in the sixth month or quarter.

Step Two. Hedging approaches

Once the hedge ratio and appropriate time horizon have been determined, treasurers can decide what style of hedging will allow them to meet their risk management needs most precisely. As figure 1 shows, this can be:

• Static (e.g., hedging for a whole quarter at the start of that quarter)
• Rolling (e.g., hedging every month for the corresponding month in the following quarter)
• Layered (e.g., hedge one third of each month for the following rolling quarter)
• Or a combination of all three

These strategies tend to produce a significantly smoother outcome compared with hedging on a spot basis, as they are based on the concept of moving averages but this is not guaranteed. In the example given in figure 2, a static approach results in the greatest volatility, with a layered approach resulting in the least volatility.[[[PAGE]]]

Step 3. A balanced portfolio

Once the hedging approach has been agreed, the next step in creating a balanced portfolio is to determine the most appropriate hedging instruments to use. When a spot is trading at the middle of its range in a mean reverting currency, there is great uncertainty about the future direction, whereas when it’s at the higher or lower end, it’s more likely to move towards the average. This can influence a treasurer’s choice over the ratio of each instrument to employ, and the tenor of hedging transactions. For example, if spot is trading at unfavourable levels, the treasurer may not want to hedge so much volume or for long term so as to avoid locking in potentially unfavourable rates. Consequently, they may favour the use of options rather than forwards for a shorter time period.

HSBC works with clients to model different approaches and outcomes, and then benchmark each strategy with hindsight to determine how successful it was, or would have been. As a starting point, let’s assume a basket comprising 25% Forwards, 25% Unhedged (Spot) and 25% Options, the remaining 25% could be hedged using any of the following three strategies:

• Spot expected to move against client – increase Forwards to 50%
• Spot expected to move in client’s favour – increase unhedged to 50%
• Unsure of Spot direction – increase Vanilla options to 50%

Scenario 3 (in figure 3) is more appropriate when the currency is trading at a long-term mean. Dynamically however it can be split on the basis of a multi-year average (30 years in this example) with tenors increasing or decreasing depending on the risk profile. For instance, assuming a GBP-USD rate of 1.3200, if a client was a buyer of GBP, their fixed hedges are likely to be higher compared with flexible and unhedged positions. As currency moves in a client’s favour, they would typically increase the hedging tenors to longer dates to enjoy the favourable rate and vice versa (figure 4).

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Forms of uncertainty

An event-type or one-time exposure needs a different set of solutions compared with the regular hedging that requires a lot of forethought in terms of analysis, prior to engaging in any hedging activities. Using the Brexit referendum as an example, institutions exposed to the affected currency pair risk found themselves balanced on a precipice from which they could be pushed in either direction, resulting in a major gain or significant loss. Hedging such a risk using fixed mechanisms, like forward contracts, removes the opportunity to derive advantage compared with leaving the risk fully open: a simple case of heads or tails, where only one of the said two strategies are likely to win. A flexible option-linked solution on the other hand came at an inflated price compared with times of normal volatility. The only factor potentially providing respite on pricing was the short duration trade, as the time value element post-referendum more or less reflected the uncertainty falling way beyond the result date.

There is no single, right or wrong mechanism to hedge FX: it depends on factors such as the cost of hedging, margins in the underlying business, currency volatility, flow certainty, budgets etc. Regular disciplined hedging, with a mix of different solutions could offer an outcome that provides reduced volatility over a longer time frame.

HSBC has discussed this approach with its clients who have greeted this dynamic, blended approach to hedging very favourably, and in many cases, it is relatively new to some treasurers. Many have upper and lower hedging bands, but they don’t necessarily use a mix of instruments, even though these may be authorised as part of the treasury policy. Witnessing the effect of the Brexit referendum on GBP exchange rates should be a catalyst to test existing policies and approaches, and refine them accordingly. There have rarely been such significant event-risk instances of a liquid currency of a developed country. For many companies, the political, economic and market volatility that is likely to ensue, not only in the UK but more widely, has effectively removed their ability to predict future cash flow, so adopting a flexible, balanced method for managing currency risk has never been so important.

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