Managing Currency Risk

Date: 18th October 2016Presented by: Paul Ward

Senior Dealer AIB Treasury Cork

Limiting the Risk of International Trade

Overview

• The implications & fallout of Brexit

• The challenges for Ireland & Irish Businesses

• Currency Market overview

• Understanding Currency Risk

• Hedging Strategies to Manage Currency Risk

• How can AIB Treasury help your Business

The immediate impact of Brexit

• Unprecedented event and nothing to compare to previously.

• Financial markets took the initial shock with stock markets and currency markets falling sharply (75p to 85p).

• Markets had settled somewhat EUR/GBP stayed in a range between 83p and 85p.

• Since end of September, Sterling has continued to weaken, trading above 90p.

• UK economy had grown steadily in recent years and in the run up to the referendum.

• UK is best performing G7 Country in 2016, however IMF have downgraded growth forecasts for 2017 & 2018 for the UK economy.

• Growing concerns regarding UK Growth, Competitiveness and Political Stability.

• Will have profound economic and political consequences for the UK, Ireland and the EU over the next number of years.

The Fallout of Brexit – Major challenge for Ireland

• Serious implications considering close economic/trade links between Ireland and the UK.

• UK trade equates to circa 35% of Irish GDP.

• Negative Brexit impact on UK growth will have knock-on effects for activity in Ireland.

• Key for Ireland is the trade arrangements put in place between EU and UK post Brexit.

• Higher trading costs from administration, differing trade rules, possible custom posts and duties.

• Would impact the considerable cross country investment between Ireland and the UK

• Agri-sector, tourism, energy, retailing, financial sector likely to be most impacted.

• UK is a very important market for Irish food exports in particular.

The Fallout of Brexit – Major challenge for Ireland

• Brexit a major issue for Ireland given its strong trading links with the UK.

• Border with Northern Ireland could become an external EU land border. Possible restrictions on freedom of movement, passport controls, customs posts etc.

• Ireland will lose a key ally within EU when UK leaves.

• Irish economic growth to be lower in 2017 & 2018 in the run up to Brexit on weak Sterling and UK slowdown.

• Main risks to Irish economy are no longer internal but external, particularly Brexit.

• Sterling has already weakened against euro which hits Irish exports to the UK.

• Ireland vulnerable to any shocks that would hit export growth.

Brexit – The major issues

BREXIT

Sterling

Timing

Transition Arrangement

Future of the EU

Trade Deal

Migration

Scotland

City of London

Brexit – Potential Outcomes

Full access

to the Single

Market

Control of

EU Migration

Influence

over EU

Regulations

Tariffs on

goods

Contribution

to EU budget

Norwegian Model (EEA)

Consultation,

NO voting

rights

YES

but at a

reduced rate

Swiss Model

(Bilateral Agreements)

NO

Services

excluded

* YES

But generally

quite low

YES

but much

smaller

Canadian Model (FTA)

NO

Services

excluded

Turkey (Customs Union)Limited tariff

free trade

WTO Model

* Recent Swiss referendum vote to control EU migration threathens the future of the Swiss model

Material

Change

Scale

Low

High

fxcentre.aib.ie

Overview of the Currency Markets

• Downside risks persist for Sterling as very difficult negotiations with the EU lie ahead.

• Sterling likely to remain venerable to further weakness as uncertainty continues to grow.

• EUR/GBP reached a 5 year high (91p) in early October (69p last November).

• EUR/USD trading in a very narrow range last 6 months ($1.10 to $1.14).

• US Fed slow to tighten policy/hike interest rates, chance of action in December.

• Result of US Presidential election should give some direction for EUR/USD 2017

• Growth within the European economy remains subdued

• The rise of nationalism/protectionism could be a concern for the Euro

• Central Bank actions continue to play a key roll in currency volatility

Overview of the Currency Markets (EUR/GBP 2016)

Overview of the Currency Markets (EUR/GBP 5YR)

Overview of the Currency Markets (EUR/GBP 10YR)

Overview of the Currency Markets (EUR/USD 2016)

Overview of the Currency Markets (EUR/USD 5YR)

Currency Market Forecasts

• Expression of opinion subject to change

• Main drivers

Fallout of Brexit negotiations

US Interest rate hikes in 2017

Economic performance of main economies of Europe, UK and the US

Political stability/instability

Current Q4 2016 Q1 2017 Q2 2017 Q3 2017

Euro Versus

USD 1.10 1.08-1.14 1.07-1.13 1.06-1.12 1.05-1.11

GBP 0.90 0.87-0.93 0.88-0.94 0.89-0.95 0.90-0.96

What is foreign currency hedging?

In very simple terms, currency hedging is the act of entering into a financial contract in order to protect your business against currency volatility and protect underlying business margins. The main benefits are protection and cash flow certainty. The decision to hedge - or not to hedge - depends on a number of factors;

• Treasury policy• Risk appetite• Contract certainty (committed v uncommitted exposures)• Time horizon (payment cycle)• Underlying business margins

Managing Currency Risk

Why?

If a business generates revenues or cost in different currencies, it is exposed to Foreign Exchange (FX) risk whereby currency movements can affect the margin the business earns. To mitigate this many companies choose to hedge their exposures. Hedging will:• Protect against adverse movements in FX rates.• Enable accurate forecasting and budgeting.• Be the prudent approach where cashflow or margins are tight.

How long and for how much ?

• What are the business cycles?• What are the business margins ?• What line of sight have exists of upcoming exposures?• How much rate certainty does the business require?• What is the market view and what is the appetite for risk? • What is the business your budget rate – how does this compare with prevailing market rates and trends?

Why Hedge? How long? How Much?

Traditional methods of hedging FX exposures

Traditional methods of hedging FX include:

• Natural Hedging

• Spot Rates

• Forward Contracts

• Vanilla FX Options

• FX Market Orders

Traditional methods of hedging FX exposures

Natural hedging

A natural hedge is the reduction in risk that can arise from an institution’s normal operating procedures. A company with significant sales in one country holds a natural hedge on its currency risk if it also generates expenses in that currency.

For example, a company selling product into the UK is (partially) naturally hedged against the moves in EUR/GBP, if it can transfer some of their costs into GBP. For example:

• Ask for your distribution company to quote you a fixed GBP price*

• Pay your UK based sales person in GBP

• Switch some input costs to GBP, such as the plastic required for the tub

* Note, this doesn’t require moving to a UK supplier. As their costs will largely be in sterling, you may assist them in gainingnatural hedging also.

Traditional methods of hedging FX exposures

Spot Rates

You book the prevailing rate in the market as your receive incoming FX currencies or as your FX payments fall due.

Main Features

• No cash flow certainty

• Underlying business margins not protected against adverse FX rate moves.

• Free to benefit from any subsequent favourable exchange rate movements.

• No obligation to deal should your circumstances changes (i.e. you do not run the risk of incurring a breakage cost).

• No credit limit required.

Traditional methods of hedging FX exposures

Forward Contracts

A forward contract is an agreement to exchange currencies on an agreed date in the future (or during an agreed period if you would like some flexibility around the date) at a fixed exchange rate. This is called the forward rate, and is based on the spot rate of the day plus / minus the relevant forward points.

Main Features

• Cash flow certainty and underlying business margins protected against adverse exchange rate moves.

• Unable to benefit from any improvement in FX rates, as you have committed to dealing at the agreed rate.

• You are obligated to deal as per the agreed contract. If your circumstances change and you need to reverse out of that transaction you may be liable for a breakage cost.

• Forward limit is required.

Traditional methods of hedging FX exposures

Vanilla FX Option

A Vanilla FX Option is like an insurance policy. In return for paying a premium, you buy the right, but not the obligation, to buy or sell one FX currency against another on an agreed future date, at an agreed rate (the strike rate).

There is no obligation on you to exercise your option. Therefore, if the spot rate on expiry is better than the strike rate, you can deal at the more preferable spot rate. This gives you unlimited potential to benefit from any favourable FX moves with 100% protection at the agreed strike rate.

Example - You want the right but without the obligation to sell GBP £500k at 0.9300 on the 30th of December 2016. In exchange you pay a premium of €8,500

There are two possible outcomes on maturity:

1) The spot rate is lower than 0.9300, so you sell your GBP at the lower prevailing rate

2) The spot rate is higher than 0.9300, so you exercise your right to sell at 0.9300

Note: No matter what the outcome, the premium is non refundable, however if you want to sell your option back to the bank at any time, it will most likely have a value prior to maturity

Traditional methods of hedging FX exposures

Market OrdersFX Orders are used by businesses aiming to achieve a specific exchange rate in order to protect or maximize profitability on trade transactions.

Market Orders come in 2 forms:

Take Profit Order - You give an instruction to the bank to exchange a fixed amount of one currency for another currency should the market reach a specified exchange rate that is more favourable to you than the current market rate.

Stop Loss Order - You give an instruction to the bank to exchange a fixed amount of one currency for another currency should the market reach a specified exchange rate that is less favourable to you than the current market rate. This limits the degree to which you are impacted in the event of an adverse move in the exchange rate.

Note - Once the market order is filled, a spot deal or forward contract can be processed.

Spot Rate Forward Contracts Vanilla FX Option

Exchange rate protection?

No Yes Yes

Certainty of Rate? No Yes Known Worst Case Rate

Able to participate in beneficial rate moves?

Yes No Yes

Upfront Premium Payable?

No No Yes

Potential Break Cost? No Yes No

Which Product is right for my company?

In most cases, some combination of the above is the most appropriate way to tailor a solution specific to your hedging requirements rather than choosing a single product.

What next?

• Understand your business and specifically your treasury requirements

• Formulate a treasury policy which is suitable for your business

• Set periodic currency budget levels

• Develop an awareness of the markets and the risk mitigants

• Be disciplined – most Irish companies use a combination of spot and forward FX

• Pick up the phone

How can AIB Treasury help your business?

• Assist you in formulating a treasury policy

• Proactive calls/emails/texts on foreign exchange rate movements

• Comprehensive data available from our economic unit

• Competitive pricing and effective deal execution

• Meet our key customers regularly

• Provide informed advice

paul.c.ward@aib.ieAIB Treasury CorkPhone - 021-4271383

ANY QUESTIONS ?

Thank you for listening