Currency hedging tips

[jamesbrown]

MyCo has a large exposure to (future) USD earnings and I'm looking to hedge some of this risk, as I believe there's quite a lot of negative news already baked into Cable. From what I've read, I can see two basic options, one being to purchase a forward contract with a clearing bank, where the amount, rate (and cost) is fixed now and a deposit is required to cover the risk of default. Another option is a spot carry trade, where the trade remains open and the cost is proportional to the interest rate differential between the two currencies, until closed. MyCo has both GBP and USD current accounts.

The future USD earnings are certainly not guaranteed, so I'll need to be conservative. Am I missing other options? Is there such a thing as a currency put option, where the option to trade, and not just the execution date remains open or an option to trade within a range of amounts? Otherwise, I'm likely to hedge an amount that has very little risk of not being acquired; I have a few US clients, but there's always a risk that some or all of these contracts could be terminated.

Anyway, I'd be interested for input from anyone that has experience of currency hedging on their overseas contracts or fx trading more generally. Up to now, I've exchanged at the spot rate, which cost-averages over a period of time, but Cable is currently at multi-year lows. Perhaps it's more hassle than it's worth though...

[rambaugh]

Why can't you do both and hedge your bets? The only decision you then need to make is what percentage of your USD earnings do you convert using a futures contract instrument vs how much you do on a regular basis (cost averaging strategy) using spot deals. I'm assuming you are wanting to convert to GBP (home currency) on a regular basis as you remit invoices, say once a month?


Given the GBP is currently at a multi year lows against the USD you might use a higher percentage of earnings to spot trade as the forward contracts generally price in future risk so conversion rates will be in their favour.

[jamesbrown]

Why can't you do both and hedge your bets? The only decision you then need to make is what percentage of your USD earnings do you convert using a futures contract instrument vs how much you do on a regular basis (cost averaging strategy) using spot deals. I'm assuming you are wanting to convert to GBP (home currency) on a regular basis as you remit invoices, say once a month?


Given the GBP is currently at a multi year lows against the USD you might use a higher percentage of earnings to spot trade as the forward contracts generally price in future risk so conversion rates will be in their favour.

Yes, that's essentially how I see it. I'll need to be conservative in projecting the USD earnings, because they're not guaranteed, so there's going to be a fairly large residual that will be converted regularly at the spot rate. However, I'd also like to hedge a sizable chunk of future earnings at the current rate. Ultimately, all of this is a bet on current vs future spot rates, but the point is that currencies frequently depart from fundamentals (interest rate differentials) for an extended period. I see quite a lot of negativity baked into the current spot rate, so I'm essentially betting on the future rate being in my favor (after costs), not theirs. Even if I'm wrong, I'm happy at this rate, being at multi-year lows, and it seems worthwhile hedging. I've probably answered my own question to some degree, but I'd be interested in any practical advice on issues/pitfalls from anyone with experience of doing this.

[WordIsBond]

I've not done anything like this, but I do have some thoughts, if it won't bore you.

My view (always trust anonymous guys on the Internet for investment advice, by the way ) is that cable is likely to bounce before too long, especially if Sanders/Trump do well in the early primaries. Whether or not one of them being elected would ultimately be good for the US economy, they will stir up uncertainty which will hit the dollar.

Long term, the oil situation is positive for USD because they are willing to do the fracking and we aren't (at least not enough to move the markets), and negative for GBP because the North Sea oil money is getting hammered. So it may be that the rates we are seeing now may bounce due to electoral uncertainty but could be the new reality. And we could have our own uncertainty if the current leader of Labour manages to solidify his hold on his party. No matter who is in charge at Labour, fatigue tends to kick in and governments tend to get kicked out after a time, so we could be looking at the possibility of the most extreme left-wing government in Britain in decades (ever?), and the markets won't like that, and cable will move accordingly.

My view is that the move in cable recently was overdue, we will probably bounce some over the next year as electoral uncertainty hits the dollar, and then move back to where we are and maybe even lower. My approach is to bring back everything I can before the first primaries create panic about the dollar, and if cable bounces after that, to just leave what I generate in the US sitting there, maybe until after the election. By the middle of next year, I think we'll have very good rates again for turning dollars into pounds.

I have reserves and enough non-USD income that I can leave it there a long time, and I'm also getting a sort of respectable interest rate over there (rates are horrible both sides of the pond, of course), so that's a tolerable approach for me. I could lock in today's rates, but my USD income is also not all that stable -- some is sure to come in, but how much I don't know. And I can wait.

In any event, in your case I'd definitely get expert advice, at least to find out your options. Caxton, HIFX, and Moneycorp are all FCA regulated and I've used all three in the last 15 years. I'd just get on the phone and ask them what products they have to offer that would fit what you are trying to do with your outlook on cable.

I would not necessarily tie myself to one broker. I opened accounts with all three. When I want to convert funds, I log on to all three for online quotes, and phone the worst with live quotes in front of me. I ask the guy on the phone if he can beat the online quotes from the other two. Almost always, they will -- a smaller margin is better than no deal at all.

The currency brokers do typically expect you to wire the funds from your US bank, so you need to make sure you have the facility for this arranged with the US bank before finalising anything. The wire transfer fee obviously figures into the cost of the currency broker, but their rates are better and in general, any amount over maybe $10K USD you are usually better with the broker than with the banks, even with the wire transfer fee. It depends on your bank, though. I believe Citibank has around a 2% margin on FX, someone told me Everbank is only 1% (I can't confirm either of these). The currency brokers typically have a margin right around 1%. Many banks are 3-3.5%.

The wire fee means I only transfer funds once a quarter, at the most. Sure, it's only $30-50, depending on the bank, but why spend it if you don't have to? You may want to do so more frequently. But the currency brokers are the experts, they have various products available, and can probably structure something to your requirements / preferences -- for a fee, of course. At least if you talk to them, you know what your options are. It wouldn't hurt to drop in conversation that you've talked to others -- "HIFX said they could structure it like so, which is ok, but I'd like it like this." It seems a very competitive business.

[jamesbrown]

Hi WiB,

Thanks for that. I agree that the recent move has been overdone, at least in the short-term. I think the market is too optimistic on US rate rises, even though they are less optimistic than the Fed, while they are too pessimistic on UK rate rises. Perhaps Carney will use macroeconomic tools in the short term, but he's going to struggle to reign in debt-fueled spending without a change to bank rate. My only downside concern is that the BoE seems to be in denial about debt being a problem (muppets). Anyway, my current position is as much technical as fundamental, as we're approaching levels seen shortly after the crash, and that have broadly held since the mid-80s. It seems like a good time to hedge.

I have a corporate account with OANDA, so that's one option. I'll speak to a couple of banks too, as I'm aware of how to compute forwards on different timeframes, but I don't know what their residual charges might be (you can get a few pips within spot rate through OANDA and similar but, as you say, the banks are on the order of 1-2% for spot rate). To be clear, I don't have any accounts within the US, only UK-based accounts, one being in USD, and all USD invoices are paid into that account. That particular bank sets their Cable rate once per day only, so I generally wait for a day with upside, intraday, to squeeze their margin (sometimes getting better than spot rate ). However, that's on short timeframes.

Thanks!

[gixxer]

theoretically...

Theoretically, using a forward contract is the cheapest and least expensive approach.
However, a)if the size of the notional to be hedged is roughly what can be a contractors revenue during a year or so, b)given the high liquidity of cable, using a spot transaction will allow you to hedge and reduce the exposure (as you earn your money) during the year much more easily.

well there might be tax considerations, dunno where and if you are taxable