At this stage Brexit is beginning to look more like a Netflix series by the day. Theresa May’s cabinet are at war, Boris lies in wait, Europe and the UK are speaking different languages, literally, and the issue of the backstop may bring the whole house of cards crashing down.
I propose no such political intrigue nor drama in this article. Rather, I’m going to examine some practical solutions to dealing with what is one of the thorniest issues to impact the foreign exchange markets for some time. Specifically, the currency cross I’ll deal with is the EUR/GBP rate. Before we go any further let’s consider the historic context. Over the last twenty years Sterling has traded in a range of 0.57 to 0.96 against 1 Euro or thereabouts. We sometimes forget how strong a currency Sterling was! At the moment Sterling trades at about 0.89 to 1 Euro, so very much towards the weaker end of the historic spectrum. In the couple of weeks in the immediate aftermath of the Brexit vote in June 2016, Sterling weakened by as much as 11%. Between now and the day before the referendum Sterling is actually 16% weaker (and has been as much as 20% weaker from that point). Lest we be in any doubt as to the volatility Sterling, I think these numbers are pause for thought.
So, for those in receipt of Sterling cashflows, those expecting a future lump sum in Sterling or those who hold Sterling assets and are Euro denominated investors, Brexit’s next stages, are a clear and present danger to your capital. If we were to see worst case outcomes in terms of the negotiations then it is not beyond the bounds of possibility that we could see further moves of this magnitude. Parity might yet be on the cards!
So what can you do about it? Below I present some options as to how one might consider managing these risks.
- Do nothing and simply hold the GBP cash. Clearly a passive, cross-the-fingers type of strategy but depending on your view on the Brexit negotiations, this might not be the worst approach by the way;
- Enter into a forward contract locking in your future translation rate for Sterling back to Euros;
- Invest in Sterling assets and simply take a long-term view. This gives optionality as to when one might translate back to Euros and hopefully one is making gains on the investment in the meantime;
- Enter into a dual currency deposit;
- Engage in an options strategy which hedges your position.
I think options 1 and 3 are pretty self-explanatory so let’s consider the other options in a little more detail.
A forward is simply agreeing to translate at a predetermined rate and a predetermined point in the future. The beauty of a forward is that is gives one certainty around the future outcome and is as such an excellent hedge. Also, it costs nothing to put in place but one is committing to the contract and therefore must translate at the later date. Remember though hedging is not about profit. Rather it is about making certain, or more certain, a future unknown outcome. Having said this, it is worth pointing out that the current forward market is pricing in a weaker Sterling rate. So in other words, relative to the spot rate one would lock in a “loss” due to a weaker rate via a forward. However, again that is not really the point.
Dual currency deposit
A dual currency deposit (DCD) is an interest product in this context. A DCD is a product which is put in place for a relatively short period of time, say 3 months, for example, and pays a fixed rate of return which will be in excess of cash rates. However, the risk is that you are delivered into a different currency at the end of the product and this is referenced to the exchange rate in question. So, say for example, you held GBP. If the EUR/GBP rate trades within a specific – usually pretty tight – range then at the end of the three months you receive back your Sterling capital and the predetermined return. However, if that range is breached you will be delivered into Euros at the end of the term at the prevailing rate. DCDs are what I would describe as a classic Swiss private bank product. That is to say, many Swiss clients will be indifferent to what currency they hold in their portfolios. If one is indifferent as to ending up in one currency over the other due to the nature of your underlying cashflows and liabilities then one can earn a better than cash rate and being delivered into another currency isn’t the end of the world.
At its most basic form an FX option will simply give the client the option to convert from one currency into another at a future date. In reality, an options strategy is rarely “exercised”. That is to say, options will more so be used to hedge a position. So, for example, assuming one was intending to convert a future GBP cashflow back to Euros in say 3 months, then one is exposed to Sterling weakening in the meantime. The appropriate options strategy therefore would be to take out an opposing position to that exposure, so one that profits if Sterling weakens. In this way, the “loss” on capital due to translating at a weaker rate in the future is offset by the gains on the options contract.
In conclusion, to predict what will happen next in the next episode of the Brexit drama series is as tough a call as any these days. Whatever deal is done, or even in a no-deal scenario, I think one thing is guaranteed, which is lots of volatility in the EUR/GBP cross rate. As discussed in this article there are a number of options for you to consider as being exposed to this volatility may well be an unpleasant ride.
Author: Peter Murphy, Managing Director, P. M. Murphy Ltd. Regulated by the Central Bank of Ireland.http://www.pmmurphy.com/