Geistesblitz 01/19
Geistesblitz / News
16. January 2019

Geistesblitz 01/19

3-year average rate hedge using a ‘multi-EUR-GBP hedge with limited minimum rate’

Initial Situation

Despite a postponement of the House of Commons vote, the British Prime Minister Theresa May has not yet achieved the necessary majority for her Brexit plan negotiated with the EU Commission. In its vote on January 15th, the House of Commons clearly decided against it. As a result, there is still a very high degree of uncertainty regarding the timetable and modalities of Brexit: Will it proceed as planned, be postponed or even cancelled? In addition, it is completely unclear whether the current government will be able to shape the course of events at all.

The EUR-GBP spot rate has hardly moved in the last few weeks and has only briefly left the range of 0.8900 GBP/EUR to 0.9100 GBP/EUR. But is the market really so calm about a disorderly Brexit or is it just the infamous “calm before the storm”? With high forward premiums, exporters to the United Kingdom (GBP recipients) are faced with the difficult decision of either hedging well above spot today, or continuing to take it step by step and accepting the risk of being left out in the cold in case of a sudden, considerable shift in the spot rate. Besides, how would the volumes of UK exports (and the related GBP inflows) develop, if the Brexit negotiations were to fail?

In this situation, the current Geistesblitz describes a medium-term exchange rate hedge for 3 years. It offers exporters to the United Kingdom emergency cover without having to pay a premium.

The following chart shows the evolution of the EUR-GBP spot rate over the last 5 years.

Market Overview (January 11th 2019):

EUR-GBP spot rate: 0.8960 GBP/EUR
EUR-GBP forward (12.01.2022): 0.9360 GBP/EUR
Ø EUR-GBP forward (10.01.20202  12.01.2022): 0.9240 GBP/EUR

 

Multi-EUR-GBP hedge with limited minimum rate

Product description:

The exporter enters into a 3-year ‘multi-EUR-GBP hedge with limited minimum rate’ from which the client receives a payout if the daily average spot rate of the previous 12 months exceeds the guaranteed maximum rate of 1.0000 GBP/EUR.

In return, the client is committed to make a payment if the spot price at the end of a 12 month-period falls below 0.8700 GBP /EUR. The minimum rate is only valid to a limited extent:

  • The minimum rate is partial: In the first year it affects 33% of the hedging volume and in the second and third year 67% and 100% of the hedging volume respectively.
  • The minimum price is conditional: It is cancelled completely, if the EUR-GBP rate is determined at least once at or above the maximum rate (continuously in 24-hour trading).

The minimum rate initially acts on a reduced notional in order to avoid the risk of overhedging, especially in the particularly uncertain early stage of the hedge. In addition, this minimum rate has a knock-out, which means that it will no longer apply if the EUR-GBP spot rate reaches or exceeds the maximum rate 1.0000 GBP/EUR.

Indicative terms and conditions:

Notional of maximum rate: i.e. 2.000 mio GBP p.a. (in total 6.000 mio GBP)
Notional of minimum rate: i.e. 0.660 mio GBP p.a. in year 1, 1.340 mio GBP in year 2 and 2.000 mio GBP in year 3 (in total 4.000 mio GBP)
Value dates: Annually over a period of three years (16.01.2020, 19.01.2021, 19.01.2022)
Expiry dates: For the maximum rate daily fixing, calculation of the average rate at the end of the year.

For the minimum rate at the end of the year. (14.01.2020, 15.01.2021, 14.01.2022)

Maximum Rate: 1.0000 GBP/EUR
Minimum Rate: 0.8700 GBP/EUR
Knock-Out Condition: The minimum rate shall not apply, if the price threshold is reached or exceeded at least once during the term of the contract.
Barrier: 1.0000 GBP/EUR

Benefits and Risks from a client perspective:

Benefits:

  • Securing a maximum average rate of 1.0000 GBP/EUR for GBP sales over the next 3 years without paying a premium.
  • The minimum rate is only effective for a reduced notional.
  • The minimum rate does not apply in the event of an increase of the spot rate to or above 1.0000 GBP/EUR.

Risks:

  • For a part of the notional the customer commits to a minimum rate of 0.8700 GBP/EUR.
  • The maximum average rate of 1.0000 GBP/EUR significantly exceeds the average forward rate of GBP 0.9240/EUR.

In a nutshell

With the Geistesblitz ‘multi-EUR-GBP hedge with limited minimum rate’ exporters to the United Kingdom have a strategy at hand to be prepared in case of significant spot shifts in the medium term following a potential disorderly Brexit.

In return, the customer commits to a minimum rate for a lower notional amount, that accounts for the uncertainty of sales and hedging volumes. The minimum rate does not apply in the event of a significant – possibly only temporary – shift of the EUR-GBP spot rate.

About the author
Jan-Henning Becker

Jan-Henning Becker is Senior Manager at LPA’s Distribution Advisory team. He has more than 10 years of experience in capital markets, having worked at a German investment bank before joining LPA. He is CFA charterholder and has earned the FRM certificate. At LPA, Jan-Henning focuses on consulting topics related to trading and sales of risk management products.

Jan-Henning Becker
Senior Manager

Contact form



Jan-Henning Becker
Senior Manager

Contact form



Jan-Henning Becker
Senior Manager
Menu