Insight & Analysis

Brexit worries spark demand for complex currency hedges, but risks could outweigh benefits

Published: Aug 2019

Close up of pound coins

As the pound continues to fall, UK importers are using increasingly complex derivatives to navigate currency volatility that hold complex risks.

UK companies are using more complex financial instruments to navigate currency risk, according to a recent survey looking at how businesses are managing trade and the financial risks related to currency volatility conducted by Western Union. Among the 1,000-plus respondents in its FX Barometer survey, the two most common hedging products used to protect against currency fluctuations remain forward contracts and vanilla options contracts.

However, in a new development more UK businesses (24% of those surveyed) said they are using or considering using advanced options contracts such as barrier and leverage options, or Target Redemption Forwards (TARF) designed to help companies buy and sell currencies at better rates than normal.

The survey, also reported in the FT, states that while advanced options contracts carry potential risk and costs, more complex financial instruments also have their benefits, particularly for importers operating in a low exchange rate environment like the UK, where sterling has slumped to a two-year low on no-deal fears.

In many cases, advanced options contracts allow an organisation to achieve an ‘enhanced rate’ versus a comparable forward contract or basic options contract, Western Union states. The financial services group adds that if business import costs are higher than expected, companies may seek ‘cost optimisation’ focused options hedging products. Although more research is required, it says sectors facing more pressure to absorb costs are increasingly adapting their currency strategy towards these ‘cost optimisation’ hedging products.

“We have a more informed customer today,” says Alex Lawson, Western Union’s Director of Hedging. “The FX industry is improving the way it educates customers and providing qualified advice on the benefits and drawbacks of each hedging product. The availability of information on the internet around hedging strategies and products has improved too, effectively offering people more choice than before”.

Brexit to blame

Others also report a Brexit-related uptick in supply of riskier derivative products from banks and FX brokers. “Whenever there is a period of volatility in sterling you see a resurgence in the number of products being offered by banks and brokers,” says Abhishek Sachdev, Founder, Vedanta Hedging which advises corporations of all sizes on derivative strategies and notes “outperformance products” like TARFs and Targeted Accrual Redemption Rates, TARNs, are increasingly sought after – and on offer.

“An exporter could find that its profit margin is improved as a result of a massive fall in sterling; brokers and banks will argue that these products offer importers protection from further adverse currency movement, so they won’t suffer financial detriment. It’s easy to see why periods of high volatility make it easy to sell these products, but there is no such thing as a free lunch,” he says.

The problem is that these complex products carry opaque risks that are difficult even for sophisticated account directors to understand in simple terms, he warns. “They have many moving parts to them, with perhaps six or seven different legs to the trades all priced independently.” Companies can get caught out by the complexity when additional features like a ratio component, leverage or knock-out element (so-called because the strategy ends when the market hits a predetermined level; the protection disappears, and the business ends up unhedged) change the risk.

Risks

Sachdev also cautions companies against getting caught up in prolonged periods of using these products. Companies could end up buying twice as much as they need; buying at an unfavourable rate or find themselves locked into having the product for 12 months, rather than the six months they need. “There is a natural tendency for banks and brokers to churn these products. They sell one, then a month later restructure and sell another because they earn income for however long the trade is,” he warns.

Derivatives and the insurance they bring have an important place in company strategies, particularly during times of volatility, concludes Sachdev. However, their use should be grounded in a coherent derivatives policy or strategy, and businesses should also ask for advice from their product suppliers.

“Make sure you get advice from whoever is selling the product,” he says. “Many banks and brokers send reams of information but won’t offer these products with advice because it puts them under increased legal obligations. My view is that if they are offering these products, they should put their neck on the line, and give advice.”

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