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Currency hedging: a pound of cure

Sterling is strengthening. Warnings that Brexit jitters could send the pound to parity with the dollar have been replaced with superlatives about its recovery. Bets against the currency are falling. But treasurers should not let a false sense of security lull them into abandoning hedges.

The lessons of last year are enough to convince anyone. Like the wider world, UK companies were caught off-guard by the vote to quit the EU. Witness the rush to hedge after the forex horse bolted last summer and the pound slumped.

But even some businesses that were already hedged are likely to have paid a steep price. While Jaguar and SABMiller are celebrated for their long-range hedges, three- and six-month options are more common.

Currency hedges allow companies to lock in pre-determined foreign-exchange prices and protect themselves against shocks that might affect revenue or payments — like the pound falling to a 30-year low.

Once a hedge reaches the end of its life it can be renewed, but the cost may be higher. After the plebiscite, the difference in the cost of buying protection against sterling declines versus protection against gains, known as the three-month risk reversal, was even higher than in panicky 2008.

Now it has fallen back. During periods of low forex volatility, hedging tends to go out of fashion. Data from the Bank of England shows that in the three years to April 2016, volumes of foreign exchange derivatives fell.

Corporate complacency is a risk once again. Treasurers tempted to stop looking at sterling price charts need to remember a few things. The FTSE 100 may be at a record high but KPMG’s UK 50 index shows shares in companies which earn most of their revenue in sterling have yet to recover to pre-referendum levels. Sterling’s future depends on moving parts that include a Conservative win at the upcoming election, the US Federal Reserve keeping rates low and continued quantitative easing by the European Central Bank.

The legacy of the referendum will depend on political haggling. The consequence is already clear: it makes sense to hedge well ahead.

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