Currency Volatility and Risk Exposure

The fragile and often disjointed nature of the global economic recovery has bred high levels of volatility in the financial markets over the past 18 months. Currency movements have had little reprieve, with rates susceptible to violent swings as investors react to the latest economic headlines. This year has been dominated by developments within the eurozone and has seen the single currency shed over 20% of its value against the US dollar. A recent shift in market focus towards the shortcomings of the US recovery has enabled the euro to rebound, but the underlying risks within the 16-nation region remain unchanged and could quickly bring the euro under renewed pressure.

Similarly, the UK pound has endured an unstable path against most of its peers, with politics providing the source for much of the volatility. The build-up to the election, and the ensuing party negotiations, saw violent swings and large trading ranges on a daily basis. More recently, the Chancellor’s Budget proposals have given investors pause for thought as they speculate about the potential impact on economic growth.

With economic conditions as unstable as they are around the world, it has not become uncommon to see exchange rates move by over 1.5% within a single day. For those currencies considered risky assets, that trading range can be considerably more. On a slightly longer time frame, to give just one example, sterling rallied by nearly 4% against the euro during a week in June before seeing those gains eroded in their entirety in the next 10 days. With this volatility showing few signs of abating in the short, or even medium term, there is good reason for taking an extra couple of steps where possible to hedge your exposure.

Managing Your Exposure

Merely keeping a watchful eye on how the market is moving is a sensible starting point and there are numerous daily commentaries available. Predominantly free of charge, these reports will offer an informative perspective on currency fluctuations straight to your inbox.

When exchanging currency, avoiding your bank cannot be over-stressed. Their predisposed monopoly on currency transfers is fast diminishing, with a range of specialised companies cropping up that can offer a cheaper, personalised, and often more efficient service. In the UK, they are largely regulated by the Financial Services Authority (FSA) and allow the client to avoid dated transfer fees and airport style exchange rates.

One useful service that foreign exchange (FX) companies can offer is a rate watch. This allows you to devolve the hassle of constantly checking the rate over to the firm, which will contact you as and when your desired rate hits. Given the sharp fluctuations that the rates are susceptible to, it is all too easy to miss a good opportunity to buy your currency. Through this system, someone else is keeping an eye on the market for you, which can at least offer some comfort. Of course there are variables that can overshadow the effectiveness of such a process, most notably your time-frame and the target rate. If you are looking for sterling to appreciate by 10% in the space of a fortnight, there is a good chance that you will remain uncontacted. A certain degree of realism is advised.

A hedging tactic in its most basic, but arguably most effective, form calls for you to make your transfers in a number of tranches. You will never achieve the greatest amount of funds available, but neither will you suffer the greatest loss. There is nothing more painful than making an exchange in full and then watching the rate soar. Equally, to hold off making the exchange just to see the rate plummet is no less disagreeable and best avoided if possible.

Leading on from this, and providing a more comprehensive strategy, most FX companies will offer forward contracts. Rather than making your transfer on a two- or three-day basis, a forward allows you take the rate as it stands on the day up to 12 or even 18 months ahead. A forward will hedge the risk of the rate falling through the floor during the time when you are awaiting delivery of the funds. The only amount necessary upfront is a 10% deposit, which most companies will ask for. The deposit, which is fully repayable on completion of the deal, is essentially in place in the unlikely scenario that the client cannot produce the funds. In this instance, the company would then have to unwind the contract, with the deposit covering any loss incurred if the exchange rate has moved.

The predominant drawback of a forward is that it does not offer the possibility of taking advantage should the rate have moved in your favour. For that flexibility, a professional or corporate client can take out an option. This is a regulated investment product and as such requires a non-refundable premium. An option allows the client the flexibility at the conclusion of the contract to either take the rate that the currency was bought at originally if it is still favourable, or to discard the contract if they can achieve a better rate on a spot basis. In essence the client has the right, but crucially not the obligation, to exercise the contract. Given the premium required for such flexibility, options are only viable when exchanging larger sums and few firms will actually offer them to retail clients.

Uncertainty Set to Continue

Looking ahead, the high levels of volatility that the markets are experiencing look set to stay. A large number of questions remain unanswered about the stability of the eurozone. Despite the best efforts of the European Central Bank (ECB) the picture remains highly uncertain. The strength of the US economy has also come under the spotlight recently, and the ‘double-dip’ scenario is failing to fade. In the UK too, where the populace is soon to feel the bite of government spending cuts and tax hikes, recessionary pressures are yet to ease. The present disparity of opinion with regard to the global recovery is testament to the level of uncertainty that lies ahead.

The market is in a fickle state and all too easily focus can shift from one issue to another, exacerbating currency movement. For those that are exposed to these swings, some level of risk management is certainly advisable. Although there are no guarantees in what is essentially an unregulated market, the risks can be damped down and a degree of price of mind achieved with comparatively little effort.

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