There are 3 alternatives to manage your exposure:

Do nothing and simply deal in the spot market when the actual cash flow requirement arises Lock into fixed rates by way of forward contracts, Use flexible products – currency options – which offer both protection and upside potential.

Considering each alternative in turn:

Do nothing – dealing in the spot market is very simple. You call us as the physical cash flow arises (not forgetting that a spot deal settles in two days time) and get the market rate that day. This means, however, that you will not know until the day in question exactly how much sterling you will pay or receive for your foreign currency. A high risk strategy – whilst you may make additional profit, equally you may make a significant loss on a contract on which you expected to make a healthy profit.

Lock into fixed rates – as soon as you become aware that a foreign exchange risk will arise, say at the time you place an order for raw materials from the US, you book a forward contract with us. You know exactly how much those raw materials will cost you in three months. However, if sterling strengthens against the dollar between booking the forward contract and its maturity in three months, you will suffer an opportunity loss. Not only will you suffer an opportunity loss, but a competitor using currency options will be at a competitive advantage.

Use flexible products – a currency option product will offer you the potential for upside benefit if rates move in your favour – like a spot deal – but will provide protection against adverse rate movements – like a forward contract. For this flexibility we will ask you to pay a premium. Or you could use a combination of these alternatives. By using a combination of the alternatives to cover your exposure, you will retain upside potential, without paying a premium on the full amount of your exposure, and obtain protection.

A typical combination might be:
Do nothing Spot deal 20%
Lock into fixed rates Forward contract 40%
Use flexible products Currency options 40%

Let’s look at how this combination would work in practice. Your company manufactures in the UK and has a sterling cost base. You sell 75 per cent of your finished goods into the US and will receive US$6,000,000 in six months following a large order. You cover this exposure using the 20/40/40 strategy:

If exchange rates improve for you (sterling weakens – you receive more £’s for each US$), you will enjoy a better rate on 60 per cent of your exposure. This is because 20 per cent will be dealt at spot, and 40 per cent of the exposure has been covered by way of a currency option. As the spot market rate is better for you, and you are not obliged to deal under the option, you simply sell the 40 per cent of your US$ covered by the option in the spot market.
If exchange rates worsen for you (sterling strengthens – you receive less £’s for each US$), you will be 80 per cent protected. This is because you have locked into fixed rates under a forward contract on 40 per cent, and a further 40 per cent of the exposure has been covered by way of a currency option. As the spot market rate is worse for you, and you have the right to deal at a better rate under the option, you simply sell a further 40 per cent of your US$ at your chosen rate under the option.

When considering a 20/40/40 strategy it is important that you bear in mind the minimum amounts (if any) for the products you are considering using. We will always endeavour to meet your needs, even if they are below the usual minimum, if we are able. This 20/40/40 strategy highlights the benefits of using a combination of the three alternatives. In determining your own company’s strategy, it is important that you consider your company’s attitude and approach to risk:

How significant is the exposure to the financial health of your company?
How important is it that you are fully protected?
How willing are you to leave yourself open to the uncertainties of the spot market?
How important is it that you benefit from exchange rate movements in your favour?
How important is it that premium costs are kept to a minimum?  
What is your view on likely exchange rate movements?
What strategies are being pursued by your competitors?

In light of these factors your chosen strategy may alter the balance of the techniques used. In our example, if your company felt strongly that sterling will weaken against the US$, your split may be 40/20/40 – here you would gain 80 per cent of any movement in your favour, but still retain 60 per cent protection should your view prove to be incorrect.

Summary
The development of a strategy requires a full understanding of the exposure you face and the principles behind the products available to manage these financial risks.  We welcome the opportunity to discuss your foreign exchange and risk management issues with you.