While the political process of the first “Episode“ of Brexit – 24 June 2016 to 29 March 2019 – approaches it’s final scene it is quite likely* this will include a cliffhanger keeping participants on edge until the puzzle of future trade relationships is solved. In our first take, covering the various aspects of corporate treasury touchpoints to this theme, we discuss key questions corporates should have an answer to before deciding and implementing FX and interest rate hedges.
What does your Brexit risk scorecard look like?
From a corporate perspective, the impact of a potentially changing trade environment on their operating business and its margins is usually the most important goal of the Brexit risk analysis. Accompanying volatility in market risk factors is a second-order impact on such considerations – however possibly a quite correlated one. Here treasurers play a key role in the process as their decisions can assure the hedging strategy reduces the overall financial impact independent of the political outcome.
However good hedging requires a detailed understanding of potential Brexit effects on the company’s operating business and with such an integrated assessment across various business lines and departments. Below is a (non-exhaustive) example of three underlying factors to consider as well as their feedback loop to core competencies of Treasury:
- Ability to pass potential direct and indirect tariff costs to customers
While an exact quantification of this will be difficult in “normal” trade environments and nearly impossible amongst the various potential dimensions of Brexit-related trade hurdles, an understanding of the price elasticity of revenues can be essential to determine the “optimal” tenor and frequency of FX cash flow hedges. As a treasury tool, a matrix plotting the operating income effect via the dimensions “change in Sales” and “change in FX” could be useful for different Brexit outcomes. In such, the (company’s subjective) probabilities assigned to various scenarios could be illustrated by the bubble sizes
Source: HSBC; for illustration purposes only
- Supply chain flexibility
Here, the company’s ability to source input factors from different (e.g. more local) suppliers as well as the availability of additional production and/or storage capacities are important considerations for the underlying business. By having the opportunity to extend financing volumes and tenors for higher working capital or larger investments required, treasurers can reduce the financial cost related to such adjustments. Further such adjustments might trigger a different sensitivity to FX and interest rates and according review of existing hedging programmes
- Competitive landscape
Besides the company’s own strategy in preparing and adjusting to whatever the “new normal” of UK – EU (and UK – Rest of the World) trade relationship will be, any change in such might open the door for further competition or a change in the peer group’s pecking order. Treasury can help by investigating the hedging programme and KPI information published by its peers – e.g. for fixed-float balance of financial debt, forecasted cash flow hedging tenors and instruments as well as extent of group equity protection through net investment hedges. This analysis will allow the company to identify areas where its exposure after hedging provides a competitive advantage that can be utilised to maintain or improve the company’s market position post Brexit.
Good hedging requires a detailed understanding of potential Brexit effects on the company’s operating business and with such an integrated assessment across various business lines and departments
A risk scorecard on the above and potential further metrics can help corporate decision-making. While the risk score obtained and the corresponding need for an adjusted risk management approach will vary significantly amongst corporates in various sectors and different international footprints, the short time remaining within Episode I has increased the urgency of Plan B (or even Plan C, D, E…) being available for implementation.
Stay tuned as we will take a closer look at some of those implementation measures in the next edition of our newsletter.
* A further scenario still possible (but openly rejected by the UK government) would be a revocation of Brexit which would leave Episode I as a rather surreal picture in retrospect.
This article was finalised on November 30th based on the Brexit-related information at that time.
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