I received an email from a friend yesterday. She is currently taking a year out and taking on some voluntary work to promote peace in the middle east. It’s such a fantastic thing to do in my opinion and I have a lot of respect for her for doing it!
However, it seems like even she can’t avoid the credit crunch which is impacting us all at home. I’ve written about the fall in the value of the Pound before on this blog. £1 would buy you $2.05 at the start of the year, now it would buy you about $1.50.
And that’s really, really bad news for anybody who has income denominated in Pounds and costs denominated in dollars. If the gap year cost $8,000 at the start of the year, that would have worked out around £4,000. That cost has now increased to over £5,300. That’s a huge shortfall in funding and now she thinks she might have to cut the gap year short which would be a real shame. My prediction is that we’ll see a bounce in the value of the British Pound soon but obviously the exchange rate is very volatile. That’s a big problem: the cost of everything (accommodation, food, etc.) in terms of your home currency can change dramatically from day to day.
The volatility of exchange rates poses extra risks both importers and exporters. Somebody (or some company) buying products in dollars and selling them in pounds will have seen their costs rise by 33% in just the past few months. That could easily make the difference between a healthy profit and a huge loss.
Reducing or hedging the risk
So let’s set the scene. I’m an importer of widgets from the US. I import $1 million of widgets per month. The exchange rate is $2 to £1. So my imports cost me £500,000.
However, I believe the pound is overvalued. I reckon the UK is going to go into recession soon and the pound is going to be a lot weaker. I go to my bank manager and I ask him to guarantee an exchange rate for the next year. Obviously, my bank manager probably won’t guarantee me a rate of $2 per £1 for a whole year. The reason for that is simple: if the pound does indeed get weaker, he’ll lose out. A more realistic rate he might offer is $1.8 per £1. Providing the pound stays at the $2 level, my bank manager would have made a cut of $0.20 per £1; giving my bank a profit of $100,000.
I’m now paying £550,000 for my currency. That’s more than the £500,000 it would have cost me without the agreement, so essentially I’m paying £50,000 for the service of being able to “lock in” my exchange rate for a year. But because I believe the pound will fall in value, I don’t mind. If I could predicted a fall to $1.5 per £1, I would have known my costs would rise to £660,000. So I predict that agreeing a rate for my currency in advance would save me £110,000, in addition to giving a more stable cashflow.
What I’ve just described is an “exchange rate derivative” (or a future). The activity is known as hedging.
In amidst the credit crisis, hedging has a bad name and reputation. Imagine my company is publicly floated on the stock market at the price of £2 per share. However, a hedge fund believes that my company is overvalued or expects sales to be poor in the next quarter. The hedge fund makes an agreement with somebody (e.g. a bank) that it will sell shares in my company at the price of £1.80 in one years time. So my bank manager is sitting there and thinking: great! I’m getting a £2 share for the price of £1.80… a profit of 20p instantly! If shares in my company then fell to £1.50, the hedge fund makes a profit of 30p by offloading something worth £1.50 for £1.80.
But here is the moral issue. A hedge fund is making a profit out of the fact that my company is doing badly. In fact, the worse my profits are and the more people I have to make redundant, the more money the hedge fund will make. Isn’t this profiting from somebody elses misery?
I hope the similarities between the currency hedge and the company hedge are fairly obvious. Hedge funds make a profit out of the fact that my widget company performs badly. My widget company makes a profit out of the fact that the British economy is doing badly.
But whilst there may be a debate to be had over the morals of short selling, it isn’t in doubt that hedging can serve a positive purpose. My friend, who no longer has enough money to complete the gap year she had been planning for a long time, could have avoided being in the situation she is currently in by hedging the Pound. She would have had the knowledge that whatever happened to the British economy and the British Pound, her costs would always be the same. If the Pound fell, she would have made a profit. If the Pound later rose, she would have paid well over the odds for her gap year. But at least the cost of the gap year would be fully known and the risks from currency fluctuates eliminated.