Hedging GBP currency risk through Brexit

2020 has been a historic year, one that few of us will soon forget. With the world rightly focused on global health, economic factors, and various other consequences of the global pandemic over the past six months, Brexit became a lesser concern for the currency markets. Even as trade talks continued to make little progress, the market appeared to shrug at the increasing risk of a no deal outcome. The pound (GBP) – which has acted as a barometer of the market’s perception of how different Brexit outcomes might impact the economy – strengthened broadly during August, and the options market was indicating that there were no material risks for GBP over the next six-month period, even through that crucial December 31 date.

Recent actions by the UK government over the Withdrawal Agreement, that has caused alarm in Brussels and the threat of legal action, have not caught the market’s attention and a repricing of Brexit risks for the currency.

Implied volatility (options that show market expectations of future price swings in a currency) has jumped in the past week for GBP.

The cost to buy protection against a fall in GBP (options called risk reversals) has also increased sharply due to a surge in demand. The premium is back toward the highest levels since the 2016 referendum*.

The Brexit clock is ticking, and the chances of a trade agreement look to be fading, reminiscent of where we were in Autumn 2019. Prime Minister Theresa May was unable to progress her Brexit deal through Parliament, and with the extension of Article 50 expiring in October, GBP dropped almost 10% in three months. The risk of a hard Brexit seemed higher than at any time since Article 50 was triggered back in March 2017.

The deadlocked negotiations, and the parliamentary chaos, drove a significant increase in attention from investors and corporates exposed to a weakening GBP; as well as those looking to see how they might position themselves to take advantage of movements in GBP. Many funds had not previously hedged FX risk before but were increasingly concerned about the prospect of further depreciation of GBP and its impact on investment returns/profitability.

Back then, the focus was on hedging the FX risk through to the start of 2020, and mainly through the deployment of option products to provide maximum flexibility. When faced with a binary outcome that has the potential for large swings in a currency, hedging using an outright forward has its drawbacks. The disadvantage facing a seller of GBP was: if a deal was agreed, GBP would likely rally strongly, and they would be obligated to fulfil their forward contract at the much lower FX rate. This outcome would also mean that their hedge would have a large negative mark-to-market that, depending on the terms with their counterparty, could mean they would have to post collateral against the position.

Hedging using an outright forward also was not suitable for those businesses or funds that were looking to hedge a translational risk and therefore would not generate any cashflow to settle the contract.

A vanilla option was the favoured hedging tool as it provides the buyer 100% protection against adverse moves in the currency, while carrying no obligation to fulfil the contract. It is easiest thought of as an insurance product. In the example where the buyer was protecting against a weaker GBP, but instead it strengthened, the buyer could just walk away from the contract with no further financial implications. They are then free to trade at the improved spot or forward FX rate. However, there is a premium to be paid for this product (much like an insurance contact) which, depending on how close to the prevailing spot rate you want your hedge rate, can look quite expensive.

To avoid the upfront premium payable for a vanilla option, there are structured products that involve buying and selling an option. While there are hundreds of different strategies available, one that appeals to businesses with GBP exposure is a participating forward. This is a hybrid product, as it provides the buyer with 100% protection against adverse moves in the currency, while only obligating them to exchange a percentage of the hedged notional amount (typically 50%) at the hedged rate. The achievable hedged rate will be below the equivalent outright forward rate. This allows the buyer the flexibility of only being obligated on 50%. In a case where realised future cashflows turned out to be below the forecasts (say, where a hard Brexit hit demand), the buyer is not over hedged.

As it materialised, Boris Johnson took over as PM and a last-minute solution was found in October 2019, allowing an 11-month transition period to begin 31 January 2020, driving some recovery in GBP.

With the end of next month set as the deadline for a trade agreement, the danger of a (delayed) hard Brexit is now firmly back on the table. While it is not inconceivable that some form of extension could be sought by Westminster and agreed by Brussels, it would undermine Boris Johnson’s preference to use time pressure to force negotiations to reach a conclusion. It would also mean a further delay and cost for businesses that are trying to prepare for the post-Brexit trading arrangements.

The currency markets have not always called it right when it comes to GBP – we only need to look at the outcome of the 2016 referendum, where there was so little risk priced in that the result would end up being a vote to leave. Since then, those with GBP exposures have had heightened concerns as the various milestones and deadlines loomed, and then passed. It feels that there are still many risks around that are not yet priced into GBP – apart from the Brexit situation, there is also the possibility of the Bank of England taking interest rates into negative territory.

While the twists and turns of the last three years feels a little like Groundhog Day, the end December date looks likely to break the loop. The impact on the currency will be a sharp one, but impossible to know in which direction. If we are to learn from the 2016 referendum impact, considering hedging against it makes sense.

*Excludes the period of extreme market stress in March caused by the global spread of COVID-19