Hedging Risk: Update on market trends

Foreign Exchange Hedging

Prior to the EU Referendum vote, many businesses made last minute decisions to hedge against movements in the value of the pound. In many instances, this shielded businesses, in particular those heavily reliant on imports, from rising costs as a result of sterling falling in value. Hedging instruments typically last for 12-18 months, meaning many of the hedges put in place pre-Referendum are now due to expire and the impact is likely to be noticed by businesses and consumers alike. Retailers in particular may face an unenviable choice between pushing up prices and taking a hit on their own profit margins.

Interest Rate Hedging

Interest rate hedging continues to form an integral part of many loan transactions. Lenders often impose mandatory hedging requirements in respect of a borrower’s exposure to floating interest rates on all or part of a loan for a specified minimum period or exceptionally through to the loan maturity date.

However the risks associated with such transactions should not be underestimated, particularly in light of the scrutiny on interest rate hedges entered into by borrowers in the period up to 2009 which resulted in significant losses as interest rates plummeted. This has highlighted the need for borrowers to ensure they understand the implications that hedging may have on their underlying businesses.

In today’s low interest environment, and with the potential for the Bank of England to increase interest rates in the near future, many borrowers are likely to be attracted by the prospect of fixing their interest rates by entering into interest rate swaps. Hedging interest rates can protect both lenders and borrowers as it brings certainty to interest rate costs and hence the available cash flows from a loan transaction. This certainty means that borrowers have one thing less to worry about during the life of a loan.

Managing Risk

Getting hedging wrong can be severely costly. For example, in October of last year, Sports Direct stated that its profits would be £15m lower than expected due to unsuccessful hedging transactions. Just six months later, it announced that it now faces a 40 per cent. increase in the cost of supplying its goods following the expiry of a foreign currency hedge that had served to keep its purchasing costs low by locking in the US dollar at a favourable exchange rate.

When considering hedging, the risks as well as the benefits must be taken into account and specialist advice should be sought. In particular, the following should be considered:

• The choice of hedge instruments should be aligned to the underlying business and prevailing market conditions. So, by way of example, if you are borrowing in one currency but your revenues are denominated in a different currency, consider the benefits associated with putting in place a foreign currency swap to ensure cash generated by the business is swapped into the appropriate currency to service the debt. The risks associated with not doing this, or doing this only in part, were well illustrated in the case of the receivership sale of the Gherkin building where the senior bank loans had gone into default following an appreciation of the Swiss franc and a failure by the borrowers to properly hedge a Swiss franc loan in full. 
• When putting in place hedges in respect of loan transactions, borrowers should seek a “right to match” which enables them to shop around to find the most competitive terms without having to hedge with a lender who offers what might be uncompetitive terms.
• Borrowers should remain in tune with their wider supply chain so as not to hedge at the wrong time or for too long.
• Borrowers should hedge only the exposures that pose a material risk to their financial health or strategic plans.
• On pre-payment of any loan, interest rate hedges are usually unwound and there may be significant costs associated with unwinding these hedging transactions depending on the prevailing interest rates.
• Post hedging, it is important for the borrower to monitor the hedge and its valuation periodically to ensure that the hedge continues to meet its objectives.

Hedging is a specialist area and can carry significant risk. Businesses should strongly consider seeking specialist advice from independent Financial Conduct Authority (FCA) authorised hedging advisers. Banks and hedging providers (and lawyers!) do not advise on the suitability or appropriateness of hedging transactions.