To Hedge or Not to Hedge – Part One

Discussion and Analysis by Charles Porter

Today our social media interactions indicated an uptake in hedging options including the use of forward contracts. Specifically, corporations concerned about their exposure to import markets and international firms vulnerable to payroll and exchange transactions are seeking insure against downside risk and exchange rate fluctuations. The present uptake in hedging is explained by the strength of the Pound against the Dollar and, to a lesser yet significant extent, the Euro. This article concludes in favour of the appeal of hedging for your corporate and personal currency exposure.

The value of the United Kingdom’s Pound was certain to fall following a vote to leave the Union. This was a foreseen spill over of secession and caution was offered, although not always heeded. Whilst a devalued currency is often desired due to its capacity to make domestic exports more competitive, a sudden currency devaluation within an economy with a high marginal propensity to import is more troublesome.

The UK economy imports a considerable cross-section and volume of its total consumption. Therefore, an extremely non-negligible proportion of the Consumer Price Index representative basket of goods is either a direct import, or dependent upon imports to some extent. As the principal measure of price inflation, we can credibly assume, therefore, that a weak pound will raise inflation.

To evaluate the benefit of hedging any exchange rate risk it would be important to understand any corporate or personal exposure to currency fluctuations. However, to generalise this analysis, an evaluation of the present valuation of the Pound Sterling amongst the post-Brexit paradigm is presented.

Against the United States’ Dollar, the Pound Sterling now trades above or around Sterling’s value on the 24^th June 2016; the day after the EU referendum. From this perspective, it is plausible that the Pound may have secured a justified, or unsustainable, overweight value against the Dollar. However, in order to analyse the benefit of hedging it is necessary to establish whether the upwards correction in the value of the pound is a response to the underlying cause of its June 2016 devaluation (and thus correctively sustainable) or alternative, short-run movements.

There were two predominant and widely understood mechanisms that led to a post-Brexit devaluation of the Pound Sterling against most other currencies. In fact, due to close pre-referendum polls that were, at points, even within the estimation-error bounds, the Pound Sterling was undervalued for a hypothetical Remain decision leading up to the 23^rd June vote. These two mechanisms are similar: firstly, there is a normative (negative) value regarding uncertainty of a Brexit vote. Secondly, the more tangible threat of a preclusion from the world’s largest single market also leads to investment and trade concerns.

International and domestic investment is promoted by the Single market due to the free movement of people, capital, goods and services, in addition to a common set of laws under the arbitration of one, Court of Justice of the European Union. Whilst the ‘value’ of a Brexit is not something our analysis can capture due to the personal and individual nature of a vote within an in-out referendum, it is undeniable that the short and medium-term concerns in the absence of a concrete post-secession trading and passporting arrangement will cause speculation against the Pound.

Many of these effects generate further pressures that will devalue the currency. For example, the reduction in foreign direct investment or domestic investment due to uncertainty or deliberate flight derived from the tangible cost-benefit analyses regarding the future loss of access to a single market can potentially ruin the exporting capacity of an economy. Moreover, the current account deficit that the UK runs may no longer be financed by capital inflows. Therefore, whilst the exchange rate may make British goods appear more competitive, the performance of the economy may deteriorate. Exports must necessarily be financed by external capital flows into the domestic, British, economy. Therefore, should the automatic stabilising force be precluded from functioning, the Pound will struggle to recover and its devaluation exacerbated.

Having produced an analysis of a post-Brexit Sterling devaluation, the second part of this article seeks to understand whether Sterling’s present value is derived from a correction of the negative, post-referendum, currency effects. This in turn will inform our a conclusion in favour of, or against, further hedging based upon whether the value is likely to be sustained or short-lived.