Philippos Kassimatis explains some of the hedging strategies on offer as businesses prepare for March 2019
It was was only last week that Mark Carney said fewer than half the UK’s businesses have initiated contingency plans for a no-deal Brexit, causing alarm throughout Britain’s business and investment community. Looking at the headlines, there is a perception that manufacturers and food producers are stockpiling goods ahead of an exit. But the reality is that amid all the fear, many businesses have been preparing for the worst. Specifically, the more far-sighted have modelled various Brexit scenarios and put hedges in place to protect their currency exposures. Even for those which haven’t, there is still time.
As we observed in June 2016, a sharp currency move on the pound will not affect every company equally. For some businesses, a 20 per cent weakening of sterling could be an existential risk. For others, it would just be an unwelcome hit on sales. Others, might even welcome a weaker sterling, although importers will suffer from a devalued currency. UK companies with foreign subsidiaries might see the pound value of these subsidiaries rise in sterling terms, while international companies with UK assets might look to insulate themselves from adverse GBP moves.
While FX risk is not new, preparing for Brexit means companies will have to prepare for the worst in a radically different way. Companies that would normally not be concerned with usual currency fluctuations are putting structures in place to protect against a disproportionate move. It’s worth looking at the options available to companies.
An easy way to assess market expectation on future GBP uncertainty is looking at its “implied volatility”. This metric focuses on the levels of GBP fluctuations the market expects for a future period. Examining the GBP-USD implied volatility over three months yields some interesting results.
Even though there is a significant rise in the price of risk in the last few weeks (with volatility at around 13 per cent), we have yet to reach the levels seen just before the referendum (18 per cent). The same metric had been as high as 25 per cent at the height of the financial crisis. This means current Brexit uncertainty is still not overly priced and hedging strategies still relatively affordable. So what are companies doing about it?
Hedging structures for international companies are evolving
Over the last few months, international companies have reviewed their GBP risk mitigation alternatives, whether that’s amending supplier and client contracts or using structured financial derivatives.
A number of international firms looking to protect the value of their UK business have either taken on new GBP loans, or swapped some of their existing loans into sterling using cross currency swaps. This is particularly true of Maven’s US corporate clients who have converted parts of their dollar debt into sterling debt via cross-currency swaps as a way to protect their UK subsidiary value. We have also seen a number of UK importers seeking to renegotiate contracts into GBP with select suppliers. Although this implies passing the currency risk to the supplier, in some cases the supplier is either better equipped to hedge or has an existing portfolio of other GBP flows that can be netted off. Companies should always exhaust their non-derivatives alternatives for risk mitigation before exploring financial derivatives.
Leading PE funds have also asked us for alternatives to protect the value of their UK assets from a Brexit-driven devaluation. This is particularly relevant for funds that are close to an asset sale and risk realising a large currency loss. Conversely, a number of US funds that are looking to invest in the UK given the weaker pound are also examining different options to protect value once the assets are acquired. The high uncertainty of outcomes related to Brexit has the potential to unleash violent GBP moves in either direction. Even though this is the fundamental reason to hedge, it also implies that some derivative instruments used for hedging might incur heavy realised (losses from settled transactions) or unrealised losses (losses on paper for transactions that have yet to settle).
Simple forward structures are another good example. These instruments might suffer from large cash settlements or increased collateral requirements in a significant adverse move. For example, an importer may be concerned about the risk of a weaker GBP and stronger USD in the event of a hard Brexit. That company may choose to hedge by selling GBP (buying USD) forward for December 2019. However, if the ultimate Brexit path is not a hard Brexit, it may be that GBP has strengthened against USD significantly by December 2019, meaning that the company would have to make a large cash payment when settling in December 2019.
Options structures would be more conducive for a tail-risk event such as Brexit, but they typically have a significant premium paid upfront, like every insurance policy. Many firms are reluctant to spend cash on premia costs. This is why hedging with options is used only very selectively.
Evolving from simple forwards and options, a hedging structure that is gaining traction on Brexit protection is the protected forward. This instrument has a slightly worse hedge rate but provides a cap on the maximum loss – suitable for any Brexit-related sharp moves.
Brexit uncertainty is also affecting M&A decisions
Imagine a UK company acquiring a US company for a fixed US dollar price. If sterling devalues by 15 per cent due to Brexit between signing and closing the transaction, the UK company would have to pay 15 per cent more in GBP terms for the same agreed USD price. As a result, deal-contingent structures, where the hedge is cancelled if the deal falls through under certain conditions, have gained in popularity.
What’s clear is that a number of industries are hoping for the best – but preparing for the worst. And that means, beyond the concerns of potential pandemonium and disorderly exit, businesses are looking at all the sophisticated options available to them to protect themselves.
Philippos Kassimatis is the managing director and alongside Andy Kaufmann a co-founder of Maven Global, which advises leading companies and other organisations on their financial hedging strategies.