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Sunday, 14th April 2024
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Versatile products emerge to meet corporate treasurers’ hedging demands Back  
While conventional treasury management products are well established, the past few years has seen a range of alternative solutions become more common-place. In this article, Ciaran Cash, reviews this progression in the foreign exchange market, examining in particular the role of FX linked deposits.
The level of foreign exchange exposure amongst companies and individuals remains remarkably high. This is particularly evident when we consider the number of investors who hold assets in a non-domestic currency, be it in overseas property or equities, or indeed, how many companies sit waiting for a foreign exchange rate to move in their favour. Very often an individual or company will run up to 100 per cent of their foreign exchange risk, with no compensation if the foreign exchange rate moves against them!

Hedging these currency exposures can be difficult and often the client will simply not want to commit to a hedge. That is why the introduction of very simple financial products, such as the foreign exchange or FX linked deposit, can give the individual or company a degree of comfort in these situations. Using a FX linked deposit, an individual or company can soften the blow of an unfavourable exchange rate move.

Examples
A company or individual investor with investments in non-domestic currency: Consider an Irish investor with a portfolio of euro cash and a ?2m sterling investment in the UK. At the EUR/GBP exchange rate of 0.69, our investor sees the real value of this investment as ?2.898 million, (?2 million divided by 0.69).

As EUR/GBP moves above 0.69 the value of sterling falls. If EUR/GBP moves below 0.69, the value of
sterling will increase. Therefore, our investor would favour EUR/GBP to move lower in the months ahead.

A euro FX linked deposit can run alongside the sterling investment so that the investor is paid a higher yield if the exchange rate does not improve below a pre-agreed level.
The standard yield on a six month euro cash deposit is around 3.00 per cent. The FX linked deposit works as follows:
• A benchmark EUR/GBP rate of 0.6765 is set by the bank.
• If the EUR/GBP exchange rate does not improve over the next 6 months to 0.6765 - the bank pays an enhanced yield of 6.50 per cent on the cash deposit.
• If 0.6765 trades - the yield is zero however, the investor has an opportunity, (independent of this structure) to lock in a foreign exchange gain of nearly ?60,000 versus the original foreign exchange rate of 0.69.

This product will not provide an exact hedge for the sterling exposure. However, it will offer some compensation if the value of sterling falls over the six months. The potential downside is the reduced overall benefit if sterling appreciates below 0.6765.

Company waiting for a foreign exchange rate to move in their favour: In this case, the company is euro cash rich but with an ongoing requirement to purchase US dollars, (US$1 million per month).

The corporate treasurer only buys US dollars forward when the exchange rate is at a favourable level. Until then, the company are happy to continue buying US dollars each month as required in the spot market.
In this case, the FX linked deposit can work as follows:

The current EUR/USD rate is 1.28. The bank sets a benchmark level for EUR/USD of 1.34. The company wants a EUR/USD rate as high as possible as this reduces the price of the US$1million dollars each month.
• If the EUR/USD exchange rate does not improve to over 1.34 in the next 6 months - the company are paid an enhanced yield of 6.50 per cent on the cash deposit.
• If EUR/USD trades above 1.34 - the deposit yield is zero, however, the company stands to make a foreign exchange gain as the exchange rate has improved significantly from the original 1.28.

Conclusion
The FX linked deposit is a very versatile product. Almost every variable can be tailored to suit the company or individual requirements, such as the currency pair, deposit yield or duration of the deposit. The minimum yield can also be increased from zero to provide some return on surplus cash. Most importantly, capital is protected. However, the deposit balance must be maintained to maturity.

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