As companies and high net worth individuals make international investments or take on international exposures, they are subject to the changing value of currencies. The dollar cost of running a factory in the U.K., for instance, can change dramatically as the exchange rate of the pound fluctuates — as it has recently in response to uncertainty over Brexit.
But in markets, volatility equals opportunity, and a carefully structured investment strategy with a solid risk-mitigation component at its core can help achieve a range of financial objectives.
Prepurchasing foreign currencies can provide a hedge that effectively flattens currency rates. For businesses drawing up their future investment and spending plans, this is critical to bringing predictability to the costs of overseas exposures and the value of any capital they decide to bring back home. They can also cost average their purchase over a couple of days, weeks or months.
Trade disputes and Brexit roil markets
Interestingly, currency volatility has tapered off this year as geopolitical tensions have caused investors to take a sit-and-wait view of the market. But those risks remain and could strike market sentiment at any time.
In London, for instance, the pound had been rallied from six-month lows after Prime Minister Boris Johnson announced he’d forged a new deal to leave the European Union. Its rally was muted as legislators rejected the plan and the country was thrust toward a general election.
However, little has unsettled global markets as much as the yearlong trade dispute between the United States and China. Leaders of both nations have traded barbs and punitive actions, interspersed with announcements of progress toward a settlement.
Foreign exchange market swings make life tricky for businesses. They may find planning difficult because treasury departments and decision-makers can’t predict their foreign currency obligations from one month to the next; changes in the value of a currency will result in a rise or fall in the cost or value of an asset exposed to it.
First Republic Foreign Exchange Advisors guide clients to understand these risks and manage them. They also enable clients to mitigate or reduce their overall currency exposure.
A plan for everyone
A wide variety of hedging products can be utilized based on clients’ risk appetite and hedging objectives. Using forwards, options, structured solutions or simply cost averaging can help manage foreign exchange risk.
One of the simplest strategies is known as an outright forward, which is a contract that locks in a currency’s exchange rate in order to meet an obligation in the future. These hedging strategies are binding obligations that help reduce any currency risk associated with an exposure. Their relative simplicity makes them especially suited to startups or other companies entering international markets.
One such company, a West Coast–based biotech business advised by First Republic, needed help managing payroll and overhead costs at its manufacturing operations in Ireland. The company had monthly obligations of around €1 million, but market volatility made it difficult for the firm to predict the month-by-month dollar value of its overseas costs.
To bring predictability and accuracy to the dollar cost of those obligations, the company bought a strip of forward contracts that locked in a predetermined rate on the euro for each of the 12 months its payroll came due.
Outright forwards are binding obligations, meaning buyers won’t be able to capitalize when currency markets move in their favor. In the case of the biotech firm, this was less a priority than providing a level of predictability and stability to its expenses.
In this way, First Republic Foreign Exchange Advisors act as trusted partners to treasury departments. With access to a robust number of liquidity providers and a full stack of back-testing and risk-assessment tools, clients can take advantage of risk management services that growing companies may not have access to.
Sophisticated solutions for complex needs
Clients with more complex needs may require more sophisticated hedging strategies. For these clients, there are variations of a forward contract, or they can use currency options.
If a firm knows that a foreign currency obligation will come due but is not sure exactly when, it could utilize a window forward contract. This is a more flexible alternative to an outright forward contract because it enables the buyer to set a start and end date during which it may draw down on a fixed dollar amount at a locked-in foreign exchange rate.
For a U.S.-based nonprofit client of First Republic, this proved an effective strategy for hedging against currency risks associated with paying for an annual corporate trip to Israel. While the yearly nature of the trip was predictable, the exact timing usually was not.
To facilitate payment, the nonprofit would execute a window forward contract to buy Israeli shekels, allowing it to lock in the exchange rate for a window of time in the future.
For those clients looking for a hedge that both provides protection from adverse moves in the currency markets and is able to capture upside moves, foreign exchange options can be a good fit.
A technology company advised by First Republic implemented an FX option strategy whereby it purchased a sterling call (buy) option that placed price protection around its sterling-denominated year-end bonuses. This strategy can be viewed as placing an insurance policy around a cross-border obligation; if the market moves against a client’s exposure — causing the purchase of sterling to become more expensive — the client can exercise its right to buy the currency at the more attractive level.
Foreign exchange markets can be daunting, and in tumultuous times such as these, they can prove costly to internationally exposed companies and individuals. But with the expertise of advisors such as those at First Republic, tailored strategies can offer insurance against even the wildest currency fluctuations.