Hedging Brexit's Foreign Exchange Risks

Posted: Dec 15, 2017 8:00 AM
Hedging Brexit's Foreign Exchange Risks

The economic landscape of the world has been shifting dramatically over the past few years, and one of the largest potentials for a global shakeup will be seen when the United Kingdom (UK) exits the European Union (EU). The event, also known as “Brexit,” is scheduled to happen at the end March 2019 and has enormous implications for Europeans and investors around the world. The departure of the UK will destabilize the EU and introduce new bureaucratic barriers to conducting business between the two entities. However, the most concerning aspect of Brexit is that nobody truly knows the impact of the event – the UK government has not completed an impact assessment and much of the impact is speculative. Ultimately, the only guarantee is that Brexit will shake things up for the EU and the UK The threat of UK’s departure has already disrupted the UK economy.

Brexit’s Cloud of Uncertainty

Perhaps the greatest risk associated with Brexit is the uncertainty of it. Economists are unsure of the extent of consequences associated with separating the UK economy from the EU.  In fact, the UK still has no idea what the consequences of Brexit are, as no impact assessment has been completed an 18 months after the vote for Brexit. The UK has been a member of the EU since 1973 and the country’s economy has grown alongside the EU’s for the past 44 years.The threat of separation has already had a negative impact on the UK economy. Inflation has accelerated to a four-year high and the economy has only grown by 0.3%, down from the 0.8% growth rate from the year before. GPB has also become weaker compared to international currencies, which means that certain goods and services have greatly increased in price. In fact, the instability has caused many international companies to redirect much of their operations outside of the UK: HSBC’s clients are requesting trades to be routed through mainland Europe instead. Major investment banks are moving jobs outside of the UK, and companies are looking to shift headquarters outside of London. More importantly, many businesses headquartered in London will face significant hurdles if the UK leaves the EU. If trade rules remain as they are today, the financial and automotive sectors are some of the most threatened by Brexit, as they operate on an international scale and a significant number of jobs are threatened if rules post-Brexit are not hashed out clearly. More importantly, there is still uncertainty on whether or not Brexit will actually occur, as there are political factions within the UK that are actively lobbying to not follow through with Brexit.

Forward Contracts to Hedge Against Exchange Risk

Brexit brings many risks to the process, but being able to protect against certain risks is essential to being able to weather the storm. One of the easiest risks to protect against is the risk of changing exchange rates – or currency risk. The most common way to hedge against currency fluctuations is through a financial instrument called an FX Forward. A forward contract is an agreement that allows an investor to buy or sell a currency pair (USD:EUR, for example) for a future date with a guaranteed exchange rate. Typically, the exchange rate is today’s change rate, which means that the forward contract eliminates any risk associated with exchange rate changes by allowing today’s exchange rate to be used on the day the contract is exercised. As a hedging tool, this is invaluable for both individuals and corporations as it completely eliminates uncertainty and risk. From the perspective of an individual, a forward contract can be used to eliminate risks with big purchases, such as buying property abroad. For example, if a UK citizen was purchasing an overseas property and had to deliver funds after the Brexit referendum passed, they would have seen the cost to purchase the property increase by almost 15% due to the huge drop in the value of GBP. In this situation, signing a forward contract would have protected them against any shift in currency rates, and they would instead have been able to exchange GBP to EUR at a more favorable rate.

Company Use of Forward Contracts

It’s important to realize that forward contracts are even more valuable for companies, especially those that conduct operations around the globe. A huge number of operations can see protection through forward contracts, such as hedging against currency fluctuations when buying heavy machinery from overseas or hedging on-going receivables and payments against fluctuation. If a company has a significant revenue stream overseas, hedging their earnings with forward contracts will allow them to lock in that income, therefore protecting the corporation from adverse currency movements that could wipe out that revenue and crush profit margins. Most importantly, forward contracts can be used to eliminate as much currency exchange risk as possible from operations and revenue streams, so that an unlucky currency movement will not cripple profit. When Brexit passed, one of the short-term effects was that the British Pound greatly decreased in value which meant that foreign goods and services became significantly more expensive. In fact, the shift in value became so great that it caused a price dispute for the supermarket chain Unilever, where certain goods became temporarily unavailable to British citizens over who should absorb the price of more expensive goods: Unilever, British citizens, or the supplier? This argument could have been avoided entirely if forward contracts were used to lock in the exchange rate so that the relevant risks were from increased operational costs or cost of raw materials rather than exchange rates.

Using Currency Forward Contracts to Mitigate Exchange Risk

It’s obvious that the effects of Brexit are still unknown both for the British government and the EU. While it’s not known the extent of changes that Brexit will cause, it’s already clear that Brexit has caused a significant change in the UK economy and has threatened their ability to do business with confidence. This has been seen in the decline of the Euro and British Pound as well as the actions of international corporations that have looked to move headquarters and jobs into mainland Europe. Amid all the risk factors associated with Brexit, being able to mitigate currency risk with forward contracts is one step towards economic stability for the region.