The Review of Q2 and what to expect from Q3

The Review: Q2 and what to expect from Q3

Jeremy CookChief Economist and Head of Currency Strategy

Your Presenters

Rick RoacheHead of Corporate Dealing and Structuring

• Negotiations and Models• Timelines and fallout• EU and further referenda• The Bank of England• The Government• The pound

So What Now?

• There is no precedent. Plans and the processes to leave the EU were only drawn up in the Lisbon Treaty of 2009.

• The most important thing to remember is that the EU would act without the involvement of the UK and that would limit the negotiating power of a newly independent UK.

• Laws would be repealed and reinstituted as well as draft laws changed. We would still be subject to EU rules and regulations in the meantime however.

• Indeed, should a Brexited UK wish to keep access to the Single Market then budget contributions would still have to be paid, free movement continued and the continued supremacy of EU law over the single market upheld.

Negotiations

What model would we adopt?

Source: Citibank

The timeline

Source: Barclays

The fallout

Could lead to the end of the European Union and trigger further referenda

Monetary policy

Fiscal policy

reaction

Sterling and the euro

EU and further referenda

• First impetus would be lower in the UK although further QE spending more probable.

• BOE may let inflation run hot should deprecation boost CPI in stagflation push

• Delays Fed rate rise by 9/12 months at least – current thoughts sit at September

• Further policy easing globally triggers ‘currency war’ like conditions

• ECB to further cut into negative territory

Monetary policy

• IFS paper warns of additional austerity for the British people larger than current fiscal consolidation.

• Brexit campaigns talk of £8bn in savings but a small slowdown in growth can easily eat up £8bn

• Have to think that Osborne wouldn’t still be in place in the event of a Brexit. Can Labour take advantage?

Fiscal policy reaction

• GBP cracks by 15-20% vs USD and other havens

• EUR strengthens initially but relative strength of economies and monetary policies a factor

• Commodity currencies to take a hit on a global trade

• Have to view the USD as the overall winner in this

Sterling and additional FX

• The answer depends on what kind of arrangement the UK came to with the EU.

• Germany will want to make clear that disrupting the EU does not come without costs. Even if a deal were on offer, it is unlikely to come without a requirement for the free movement of labour, as in the Swiss case.

• WTO tariffs: The EU protects agricultural markets strongly, for example. Exporters of dairy products or meat might find themselves facing tariffs of 30 per cent or more - enough to make exporting impossible for many companies. A lower sterling may help this however.

• Inward investment, both from EU countries, and from countries which see the UK as a gateway to the EU markets and there is little incentive for a European firm to set up new production facilities in the UK if they would then face barriers to selling back into Europe.

Small business fallout

Forecasts

Q3 2016 Q4 2016 Q1 2017 Q2 2017

GBPUSD 1.25 1.22 1.20 1.25

EURUSD 1.06 1.04 1.00 0.98

EURGBP 0.85 0.85 0.83 0.78

GBPEUR 1.18 1.17 1.20 1.28

GBPJPY 126.25 119.56 120.00 131.25

USDJPY 101.00 98.00 100.00 105.00

AUDUSD 0.70 0.70 0.68 0.66

NZDUSD 0.64 0.62 0.60 0.58

GBPAUD 1.79 1.74 1.76 1.89

GBPNZD 1.95 1.97 2.00 2.16

These comments are the views and opinions of the author and should not be construed as advice. You should act using your own information and judgment.

Whilst information has been obtained from and is based upon multiple sources the author believes to be reliable, we do not guarantee its accuracy and it may be incomplete or condensed.

All opinions and estimates constitute the author’s own judgment as of the date of the briefing and are subject to change without notice.

Foreign exchange risk arises when your company is exposed to a financial transaction in any form that is denominated in another currency. Your company can be exposed to this risk through a number of channels – most notably:

Risks

Transactional Translational Credit Risk Liquidity Risk

Forecasted FX Exposures

Balance Sheet Adjustments Default Risk Liquidity Events

Accounts Payable Foreign assets / liabilities Concentration Risk Margin Calls

Accounts Receivable Tax obligations Counterparty Risk

Capital Expenditure Foreign CCY loans

Significant Company Purchases/M&A

What are the risks my company could be exposed to?

How to visualise your risk-return trade off

-5.00% -4.00% -3.00% -2.00% -1.00% 0.00% 1.00% 2.00% 3.00% 4.00% 5.00%0

0.01

0.02

0.03

0.04

0.05

0.06

0.07

0.08

0.09DISTRIBUTION OF RETURNS

Returns above/below 0%

Pro

babi

lity

Probability distribution is one of the most effective ways to visualise the dispersion of your returns and your inherent risk. Depending on your portfolio of products, your dispersion, or distribution, of risk will differ. The probability distribution curves pictured show normal distribution. That is, the positive and negative risks to your portfolio are symmetrical and are equally as probable.

Having a riskier portfolio will increase the probability that your portfolio will result in excess returns/losses, and decrease the extent to which your returns are dispersed around zero – as shown by the green curve.

More Risky More RiskyRisk Neutral

LESS RISKY PORTFOLIO

MORE RISKY PORTFOLIO

100% Certainty0% Flexibility

Portfolio of spot, forward and options contracts

Protection with potential upsideProtection of a portion of the exposure

Forward contracts Spot deals

Fully Hedged Wholly unhedged

What are your Hedging objectives?

0% Certainty100% Flexibility

2012 2014 20150.675

0.725

0.775

0.825

0.875

A static hedging program can be used to protect a budget rate by purchasing forward contracts to cover your budget rate for a chosen period. Upon a new hedging period, a new set of forward contracts are purchased to cover the following hedging period.

Static Hedging

Static Hedging Program

EUR/GBP

Disadvantages• You do not benefit if rates move in

your favour• As with a forward contract, you

may have to pay an initial deposit• If rates move against you, you

may need to pay a margin call in order to keep the position in place

Advantages• Allows you to forecast

transactable future FX rates

1Month: 2 3 4 5 6 7 8 9 10 11 12

Source: ECB Daily fix, World First DataNote: the above is an indication of past performance and is not a reliable indicator of future results.

Time Horizon: Long, Medium, Short term view

Selecting the length of your program is critical to ensuring you meet your hedging objectives. Whether your business can forecast your exposure 3 months or 3 years in advance – we’ve got you covered.

How far forward do you require cover?

0 Months 6 Months 12 Months 18 Months 24 Months 30 Months 36 Months

Length of Hedging Program:

HEDGING PRODUCTS

INVESTMENTS AND FOREIGN EXCHANGE CAN GO UP AS WELL AS DOWN AND INVOLVE THE RISK OF LOSS. PAST PERFORMANCE WILL NOT NECESSARILY BE REPEATED IN THE FUTURE.

For many corporates, hedging will have one purpose – to achieve a pre-determined budget rate. Your budget rate will be the rate you use to forecast your future international transactions (whether you’re paying suppliers, issuing invoices or exporting your produce) and will inform your company-wide forecasts on performance.  Your attitude and flexibility toward this budget rate will inform your hedging objectives:

Your Product Portfolio

Forward Contracts and Variations Will allow you to fix a rate for up to 3 years, based on the interbank exchange rate at the time of booking – this gives you a guaranteed rate at which to transfer up to the point at which the contract expires.

Spot ContractsAllows you to fulfil your payment requirements with minimal notice. You’ll know exactly how much you’re paying up front, and how much the recipient bank account is due to receive.

Protection with Potential UpsideLike a forward contract, a protection option will provide you with a guaranteed rate at which to conduct your future transactions. Unlike a forward contract, if the rates improve in your favour, you can use the improved spot rate at which to transact.

A forward contract will allow you to fix a rate for up to 3 years, based on the interbank exchange rate at the time of booking – this gives you a guaranteed rate at which to transfer up to the point at which the contract expires.

Forward contracts and variations

Your forward rate will always be based on interbank rate on the day of purchase. The difference between the interbank rate and your forward rate is a function of the interest rates applicable to each currency, the tenor of the forward contract you wish to buy and the spread World First charges for the transaction.

Disadvantages

• You may be required to pay an initial deposit• If rates move against you, you may need to

pay a margin call in order to keep the position in place

• Lowest level of flexibility• You do not benefit if rates move in your

favour

Advantages

• Protects your currency exposure from future adverse currency movements

Like a forward contract, a protection option will provide you with a guaranteed rate at which to conduct your future transactions. Unlike a forward contract, if the rates improve in your favour, you can use the improved spot rate at which to transact. You may have to pay a premium upfront for the product - this premium may give you the right rather than the obligation to buy at this worst case rate.

Disadvantages

• Upfront premium (cost) that you may have to factor into your overall gains

• Beneficial rate moves limited by the premium paid

• If rates move against you, you may need to pay a margin call in order to keep the position in place

Advantages

• You get all the benefits of a forward contract• Guaranteed worst case rate• You may benefit if the rate moves in your favour

Protection with Potential Upside

Advantages• You are protected at a rate of 1.2950.• All the benefits of remaining unhedged - you

benefit 100% if the rate moves higher to 1.3800.• Should spot on expiry be between 1.2950 and

1.2300, having never traded at or below 1.2300 during the window period, your worst case rate of 1.2950 is boosted as follows: for every basis point spot is below 1.2950 but above 1.2300, your protection rate of 1.2950 increases by the same difference.

• Zero premium.

Scenarios on expiryThis structure gives you a protection rate to buy USD at 1.2950 on the settlement date.

If the spot rate is above 1.2950 on expiry, you can choose not to exercise the protection option and instead buy USD in the spot market.

However, if spot trades at or above 1.3800 during the window period, you are obligated to buy the notional amount of USD at 1.2950.

Should spot on expiry be between 1.2950 and 1.2300, having never traded at or below 1.2300 during the window period, your worst case rate of 1.2950 is boosted by the basis point difference between the spot rate and 1.2950.

Disadvantages• If the spot rate trades at or above 1.3800 during

the window period, you are knocked in to a rate of 1.2950 and are obligated to buy the notional amount of USD.

• Should spot trade at or below 1.2300 during the window period, the opportunity to achieve a boosted rate no longer exists.

Windowed Convertible Forward

1.271.281.291.301.311.321.331.341.351.361.371.381.391.401.41 Forward Rate Hedge Rate

Spot rate at expiryH

edge

Rat

e

Advantages• You are protected at the strike rate of 1.2400.• You benefit 75% if the rate moves lower up to

1.1400.• Should the barrier rate of 1.1400 be triggered,

you benefit 25% from any upward movement (purple line)

Scenarios on expiryIf the spot rate is above 1.2400 on expiry, you benefit from the protection rate of the trade and have the right to sell USD at 1.2400 on the settlement date.

If the spot rate is lower than 1.2400 on the expiry date, you are obligated to sell 25% of the USD notional amount at 1.2400 and you can sell the remaining notional at the prevailing spot rate on the expiry date.

However, if spot trades at or below 1.1400 during the window period, you are obligated to sell 75% of the notional amount of USD at 1.2400 and you can sell the remaining notional at the prevailing spot rate on the expiry date.

Disadvantages• If the spot rate is between 1.2400 and 1.1400 on

expiry, having never traded at or below 1.1400 during the window period, you are obligated to sell 25% of the notional amount of USD at 1.2400.

• If the spot rate trades at or below 1.1400 during the window period, you are obligated to sell 75% of the notional amount of USD at 1.2400.

Ratio Forward

1.141.151.161.171.181.191.201.211.221.231.241.251.261.271.28 Forward Rate Hedge Rate

Spot rate at expiryH

edge

Rat

e

Questions

• In this document World First may comment on the potential political outcome of the UK referendum on EU membership. World First is not taking a political position and this document and the information and opinion contained herein are not intended to promote or procure, or otherwise be in connection with promoting or procuring, a particular outcome from the question asked within the UK referendum.

• These comments are the views and opinions of the author and should not be construed as advice. You should act using your own information and judgment.

• Whilst information has been obtained from and is based upon multiple sources the author believes to be reliable, we do not guarantee its accuracy and it may be incomplete or condensed.

• All opinions and estimates constitute the author’s own judgment as of the date of the briefing and are subject to change without notice.

• Any rates given are ‘interbank’ i.e. for amounts of £5million or more thus are not indicative of the rates offered by World First.

Disclaimers