Finance Dublin
Finance Jobs
Monday, 22nd April 2024
    Home             Archive             Publications             Our Services             Finance Jobs             Events             Surveys & Awards             
FOREX trading in the new EU: When trading or investing in EU accession state currencies hedge to limit the risks Back  
Irish investors and companies trading with the new EU accession states would be well-advised to consider hedging their exposure to movements in the exchange rates of the currencies, writes Aine McCleary.
TThree years ago, we bade farewell to the lira, the markka and the franc, not to mention our own cherished pound, as European Monetary Union reached its culmination with the launch of the single currency. But since May 1st, the pound is back in the EU albeit one of the Cypriot variety; the lira is back but this time from Malta, while investors and corporates are also going to get to grips with such newcomers as the tolar, the kroon, the lat and the lita not to mention the better-known currencies such as Polish zloty, the Czech koruna and the Hungarian forint.

And while the Slovenian tolar might be familiar to those who have skied the slopes of Kranskja Gora or Bled and the Latvian lat to weekenders to Riga, the reality is that of the ten countries which joined the European Union on May 1st, the vast bulk of Irish trade and investment is with the three largest economies Poland, Hungary and the Czech Republic. Most dealing by banks in the Maltese and Cypriot currencies is tourism-related and so far demand for the currencies of the Baltic states Estonia, Latvia and Lithuania - from Irish businesses and investors has been limited.

TwoSome of the currencies are already fixed pegged tagainsto the euro and these countries Estonia and, Lithuania and Slovenia are probably going to be the first, along with Slovenia, to join the single currency, probably in 2007. Of the three currencies of greatest significance to Irish corporates and investors, two the Czech koruna and Polish zioty are freely floating, while the Hungarian forint is a managed float within a +/- 15per cent fluctuation band around a central rate to the euro.

The potential volatility of the three of the most important traded accession currencies is likely to continue for some time and this means that companies and investors will have to seriously think more in terms of hedging. It seems likely that the Hungarian forint currently trading in a broad +/- 15per cent against the euro will not move to the narrower ERM2 band until next year at the earliest, while the free-floating zloty and koruna are unlikely to move to ERM2 before 2006/2007. Full EMU membership is unlikely for Hungary before 2008 while the Czech Republic and Poland are unlikely to join before 2009.

The Hungarian forint presents a classic example of the need to adopt a progressive hedging policy. In the past two years, there has been growing concern over the Government’s ability to manage the economy and particularly the growing budget deficit. As a result the forint weakened steadily through 2003 until an increase in official interest rates from 6.5per cent to a punishing 12.5per cent restored some stability.

Since that rise, it is hardly a surprise that the forint has strengthened 6per cent against the euro from the beginning of this year. Currently, the Hungarian central bank has adopted an exchange rate band of 245-325 forint against the euro although bankers generally believe that a 240-280 range is more likely. The forint is currently trading at the lower end of that range against the euro but further volatility cannot be ruled out. That makes hedging against forint exposure essential for investors.

There has been slightly less volatility in the free-floating Polish zloty and Czech koruna, but excessive budget deficits in these larger accession countries means that currency stability is by no means guaranteed. In the past 12 months, the zloty has traded in a 4.95-4.24 range against the euro and is currently at 4.70, while the koruna has traded in a 33.41-30.98 band in the same period. The koruna is currently trading just below 32 against the euro.

That means that those buying and selling in Poland have to cope with a 16per cent exchange rate volatility in the past year while in the Czech Republic, the exchange rate volatility has been closer to 8per cent. Once again, those figures emphasise the need for hedging when trading with Poland, in particular, but also the Czech Republic.

As the level of trade with the other accession economies increases in the wake of accession, investors and companies will also need to consider hedging especially against those currencies not already pegged to the euro.

There may be 10 new currencies within the European Union, but the reality is that to date the vast bulk of exchange rate hedging involves just three of those new currencies the Polish zloty, the Hungarian forint and the Czech koruna. For most of the other new currencies, either there has not been the volume of trade required for hedging or some of the currencies are already pegged to the euro or to a basket of currencies. Volumes in all currencies are expected to increase as investment activity increases in all accession states.

In the case of Hungary, most hedging comes against the background of the huge investment in the Budapest residential and commercial property investment market, while hedging against movements in the Polish and Czech currencies is largely because of demand from Irish corporates involved in trade with those countries.

The currencies may be relatively new to Irish investors and corporates, but the same hedging techniques are involved as would be the case in trading involving the major world currencies foreign exchange forward contracts (FX Forward) and foreign exchange options (FX Options).

In the case of FX Forward from Bank of Ireland Global Markets, there is an agreement to buy or sell the currency a minimum of €10,000 - at an agreed rate and agreed date in the future. This offers both investors and companies trading with the new accession countries the ability to protect themselves against adverse currency movements and lock in a favourable exchange rate long before payment is required.

The only downside here is that by fixing the forward exchange rate, you will not benefit from any favourable movement in the exchange rate during the contract period. With FX Forward, what you are buying is the security of a guaranteed exchange rate.

With FX Options, investors or corporates can either enter into a ‘vanilla’ contract or take a ‘zero cost option’. In the case of the ‘vanilla’ contract, an investor pays an up-front premium to obtain a specific exchange rate at an agreed time in the future. But the customer has the option to withdraw from the contract on its expiry if he wishes to. With zero cost options, there is no up-front premium but the contract is fixed with no option to withdraw on expiry. The customer gives up some potential upside to cover the cost of the premium but retains the flexibility of the option.

So far with the accession countries, most of the demand has been for the zero cost optionFX forward contracts. Here customers can lock into a structure where they will know exactly the most they will have to pay for goods, or the least they will receive for their own goods, from an accession state customer on the expiry of the contract.

The following Hungarian example explains just how important hedging can be when buying property or goods from an accession state customer. In this case, we have an investor agreeing to buy a property in Budapest in December 2003 for 25 million forints with payment due in April 2004.
In December, those 25 million forints would have cost just over €91,000 but the cost had risen to almost €101,000 as the Hungarian currencyweakened strengthened dramatically from 274 to 248 against the euro in the first quarter of 2004.

The purchaser of our Budapest property would have been well-advised to use FX Forward to agree an exchange rate in December 2003 for the April 2004 settlement. As things turned out, not hedging his exchange rate has meant that this Budapest investment has cost him almost E10,000 more than he anticipated when he agreed to buy the property.

Digg.com Del.icio.us Stumbleupon.com Reddit.com Yahoo.com

Home | About Us | Privacy Statement | Contact
©2024 Fintel Publications Ltd. All rights reserved.