By Olga Cotaga
LONDON (Reuters) - Coronavirus and the end-2020 Brexit deadline have left UK firms facing historic uncertainties, prompting many to find more flexible ways to protect their foreign exchange exposure -- even if these come at a higher initial cost.
The pandemic is expected to cause Britain's biggest economic contraction in 300 years and swell unemployment, debt and corporate bankruptcies. An added risk is that Britain could cast off from the European Union next year without having agreed any trade deals.
All of that makes it hard to forecast future cash flows, which in turn complicates the normal practice of using forward contracts to hedge foreign currency risks.
"What we're seeing more and more is that clients don't have confidence in their forecasts," said Jonathan Pryor, head of corporate foreign exchange at Investec, who advises clients across a range of sectors with international exposure, from consumer goods to energy.
"Fundamentally they still know that they need to hedge (so) there is a bracket of option products that some clients are deeming more appropriate to use than forwards ... due to COVID-19 demand fluctuations."
Most companies will hedge their foreign currency exposures to minimise potential volatility.
Forwards allow holders to lock in a future exchange rate with minimal costs up front. But the contracts are binding and currency swings can leave holders out of pocket.
That is making currency options, which give the buyer the right -- but not the obligation -- to buy or sell a currency at a specified exchange rate on or by a given date, more appealing.
An option does requires an up front premium but its price is set, whereas forward contract-holders must put up more collateral -- known as a margin call -- if exchange rates deviate from the 'strike' price.
That's what happened in March: as FX volatility soared to record highs above 16% <.DBCVIX>, the amount of collateral that companies had to pay rose, inflicting heavy losses and sometimes, bankruptcy.
(Graphic: Currency volatility drifts lower after pandemic-led spike, https://fingfx.thomsonreuters.com/gfx/mkt/azgpordqdvd/Pasted%20image%201594633853199.png)
Meanwhile, if revenues fail to materialise, companies can find themselves paying for hedges they don't need.
Barry McCarthy, chief executive at hedging service provider Assure Hedge, estimated half the hedging positions held by UK exporters turned loss-making when COVID-19 hit.
"Many firms did get hurt that had traditional FX forwards in place and the reason they got hurt is that many of their (business) deals were cancelled and so they didn't get their income," McCarthy said.
Coronavirus impacts companies everywhere but the Brexit factor has kept sterling implied volatility -- expected fluctuations measured by options costs -- well above that of peers, including the euro and yen.
(Graphic: Pound vs. G10 fx volatility, https://fingfx.thomsonreuters.com/gfx/mkt/oakvealdwvr/Pasted%20image%201594633942699.png)
SHORT-TERM
The hedging strategy shift is reflected in sterling/dollar option volumes, which increased 18% year-on-year in June and by 26% versus May, according to data from CME, the world's largest financial derivatives exchange.
Average daily traded volumes in FX forward contracts meanwhile decreased by 20% year-on-year in May, says CLS, a major settler of trades in the foreign exchange market.
Hedging providers said even companies that hedge years in advance are now choosing to buy three- to six-month sterling/dollar and euro/sterling options.
"The concept of optionality is now being much more understood and adopted by the mainstream SMEs (small- to medium-sized enterprises)," McCarthy added.
Hedging specialist Abacus FX said one of its client, a London-based tour operator, started using options because it was so hard to predict what the next tourist season would be like.
"In the past we simply used forward contracts to protect our margins," an executive at the tour company said in emailed comments, asking that it not be named.
But the COVID crisis prompted it "to integrate alternative and less traditional products into our hedging."
