Or pyracantha if you don’t like your neighbourhood burglars.
Last time, we looked at exposure definition, in CORPORATE CURRENCY HEDGING 101 – WHAT IS AN EXPOSURE?. Now, so let’s assume you have defined a transaction exposure and it is overseas sales in foreign currency, which needs to be hedged back into your home currency.
Your friendly banker is pushing you to buy put options, seductively telling you that the option will protect you if the overseas currency weakens, by giving you the right to sell it at an agreed price. But the best bit is that if the overseas currency strengthens, you are not obliged to sell it at that agreed price, you can sell at the actual spot price on the day.
Sounds tempting eh??? Heads you win, tails they lose. The only trouble is…….. you have to pay a premium to get into such an advantageous position. And the premium will be such that on average you lose……. not by much, hopefully. Why is this?
From a bank’s point of view, an option is more complicated to lay off or to manage – and so that extra input needs to be paid for.
The more cynical may look at it and see that an option has three inputs into its price;
Each one of these has a spread involved – and as the customer you pay the spread. What is more, this complexity makes it much more difficult to obtain comparison prices….. and the bank knows that. Guess what tends to happen when the customer cannot compare prices being offered by bankers???? Yep, they tend not to be so hot (the prices, not the bankers).
So we recommend forward sales. The prices are transparent, and the bid/offer spread is as narrow as can be. So on average you will be flat in terms of P&L, but with the benefit of predictability in your cashflows and margins.
Then there is the issue of how much of the exposure to hedge. Only you can decide that, and it will be determined by your objectives and the certainty of your exposure. If you are selling grain that you haven’t grown yet, you might not want to sell the full amount you expect, in case of a poor crop that year. This is a reason to sell less than your expected income, to avoid being over-hedged.
Also, you might want to consider your attitude to risk and regret. If you sell all your income forward, but then the currencies move in your favour, might you be beating yourself up for hedging away the benefit? This is another reason not to hedge the full amount.
In this scenario, we advise hedging with a 50% FORWARD HEDGE. That way, you have some protection if the market moves against you, but you enjoy some of the upside if it moves in your favour! Doesn’t that sound like an option, but without the premium and long-term expected loss?
PS. Can’t have a currency article without a chart – my inner-quant won’t let me. So here is cable (GBPUSD) over 5 years. Hasn’t it been range-bound for the last 12 months? Despite all the Brexit news. Damnit, I’ve mentioned the B-word. Sorry sorry sorry.