Hedge to smooth out the peaks and troughs

COMPANIES with large foreign currency purchasing exposures are increasingly turning to hedging to protect themselves, using derivative financial instruments such as futures and options. Sterling weakness means currency management has become a necessity for those who buy materials from overseas.<br /><br />Take soft drinks maker AG Barr, for example, which reported strong results on Tuesday. The company incurs significant dollar input costs, mainly from oil derived dollar products as well as agricultural commodities such as sugar and fruit pulp, so needs to ensure weak sterling and rising commodity costs don&rsquo;t hit profit margins.<br /><br />&ldquo;Our job is not to speculate on where we think foreign exchange or commodity prices will be, but to manage risk out of the business and smooth the peaks and trough,&rdquo; says chief executive Roger White.<br /><br />However, he suggests that achieving a perfect hedge against foreign exchange exposures shouldn&rsquo;t be the aim. &ldquo;We&rsquo;re not by any means perfect but what we&rsquo;ve got is a good handle on how to manage those variables. If you&rsquo;re perfect you&rsquo;re probably taking too many risks to be honest,&rdquo; he says.<br /><br />Hedging is an attractive tool for private investors too, can now hedge their own foreign exchange exposures relatively inexpensively. As well as exchange rate fixes and currency mortgages &ndash; which effectively shift loans between currencies to theoretically reduce the value &ndash; products like covered warrants offer a wide range of put and call options on currency pairs, offering cover for a relatively low exposure.<br /><br />So if you&rsquo;re off to Paris for a romantic weekend before Christmas, and are worried that you&rsquo;ll have to skimp on the champagne and truffles as sterling slips back to parity, a sterling:euro put warrant &ndash; in essence, a low risk way of shorting the pound &ndash; may be the answer.<br /><br />SG Listed Products offers a December-dated warrant with a strike price of 120p that looks interesting. You&rsquo;d only need to buy &pound;100 of warrants, at today&rsquo;s rate of &pound;1 to &euro;1.10, to hedge &pound;1,000 worth of holiday spending money. If the warrant moves above the strike price and you hold it until expiry, the most you can lose is &pound;100. But then you&rsquo;ve pretty much broken even anyway, because your &pound;1,000 is worth &euro;1,200, less &pound;100 meaning a &pound;1 to &euro;1.10 exchange rate.<br /><br />But if sterling hits parity, you still have the right to buy euros at &euro;1.20 a pound. That represents a &pound;100 profit on your &pound;100 outlay, which added to your &pound;1000 spending money means that, even at parity, you&rsquo;ve got &euro;1,200. Again, that&rsquo;s an effective exchange rate of &euro;1.10 per pound.<br /><br />As these rough calculations illustrate, this isn&rsquo;t a trade designed to make you rich, just to provide a degree of certainty over the exchange rate you&rsquo;ll get. Of course, you can improve returns by upping the stake, but then you stand to lose more in the unlikely event that sterling does in fact appreciate. But as White points out, hedging is about smoothing peaks and troughs, not profiting from speculation.<br />