Pound in Decline, How to Protect Your International Payments From Further Damage

With volatility in the British pound at elevated levels those with outstanding international transfers should be considering ways to minimise the impact of negative moves.

We are witnessing the pound teetering at the start of a new leg lower against the euro making for sleepless nights for those with imminent payments from pounds into euros.

There are ways to minimise the damage of a decline in the rate though. Here is how.

Supposing you have saved up for a holiday home somewhere sunny like Spain and let us assume you have agreed a price with the buyer of the equivalent of 250,000 pounds.

Now let us assume there is some sort of delay during the process of actually completing the purchase and it takes a few weeks to sort it out. 

A month later you are on the threshold of buying when you suddenly realise that instead of it costing you 250,000 pounds the villa now costs 264,000 because the pound has weakened by 5.6% in the intervening period, a move in the GBP/EUR rate from today's 1.2711 to 1.2000 -  a not unlikely scenario at the current time of writing.

It would no doubt come as a nasty shock, but given how volatile currency markets are at the moment, it should not, as these sorts of fluctuations are now quite common.

Market professionals, including traders at banks and treasury analysts in major corporations employ a variety of methods for managing the risk involved in transferring money from one currency to another.

They are privy to every widening variety of mind-bogglingly complex financial derivatives for managing their currency risk, including futures, forwards, options, swaps, exotics and hybrids - instruments which your ordinary man on the street is simply often not aware exist.

However, with the closed world of finance finally opening up more and competition from independent brokers, an ever widening array of these tools are now available to normal people in order to cut costs, avoid losses and even make profits when they move their money overseas.

One of the trixie, clever, financial, manoeuvres used by pros to limit currency risk is to ‘lock in’ a ‘forward rate’ in the parlance of the markets.

This can be done by using a “Forward” or “Forward Contract”, which is a contract with your broker, which contractually obliges them to use today’s rate (or another better rate) when they exchange your pounds for euros (or any other currency) at some point in the future whether its in one month's time or 3-years.

Taking the GBP/EUR example, assume you fear the pound will weaken over the next three months – perhaps because, as there is now, there is likely to be a referendum on membership of the European Union – and let’s say forecasts are placing the exchange rate in 3 months at 1.2000; that is about a 5.6% loss in value.

Instead of running the risk of realising a potential loss of 5.6% (or around 5,125 euros) by waiting three months before exchanging, using a Forward contract would enable you to lock in the current rate of 1,2616 and use that rate to exchange in three months, regardless of the spot rate at the time!

The beauty of Forward contracts is that generally there is no fee attached to them, however, the one thing to consider on the downside is that if the exchange rate improves, then the contract still stands at the original agreed rate, so you don’t benefit from the improved rate.

So for example, assume the rate went up to 1.3000 instead of down to 1.2000 – if you had a forward contract agreement at 1.2616, the contract would be honoured and the transaction would still be made at that rate – not the improved rate of 1.3000.

'Keeping your Options Open'

Currency Options can lock in a rate like Forwards, but for a small fee called a premium, can also provide the added advantage of the option holder profiting if the exchange rate improves.

With an option you lock in a desired rate for a specific amount of time – say one month as in the example of the house in Spain.

If the rate in one month is worse – so as in our example 1.2000 – then you exercise the option and make the exchange at the agreed rate – say 1.2616. As with the forward this enables you to avoid any erosion in value. 

However, the beauty of an option is that normally for an additional fee, you can also benefit from upside - so assuming the market went up not down -and reached 1.3000, you might be able to exchange your pounds for euros at that level, making 320,000 euros from you 250,000k pounds, instead of 315,400, thus actually allowing you to profit by 4,600 euros.

One thing to consider when using an option is that the broker will not always give you the total upside gain.

Currency Broker WorldFirst, for example, advertise a Currency Option on their website, which does not cost a premium, but gives you 50% of the upside gain in the event of the currency you are exchanging appreciating, whilst protection is still guaranteed against depreciation.

Stoping Losses

A 'stop loss' order is a simpler method for ensuring against a dramatic fall in the value of an exchange rate.

It is simply an order a broker places to make your currency trade if the market falls to a certain 'worst case scenario' level, thereby limiting your downside risk.

Transferring in Tranches

Another way of avoiding risk on a large transfer is to hedge in tranches, starting with half at the current rate and then having buy orders at both better and lower levels for the remaining amount.

Brokers' Rule Yea!

Before even considering how to safe-guard your desired exchange rate, however, the best piece of overall advice on making money transfers is to use a broker rather than a bank.

Brokers can generally obtain a better exchange rate for you, are often willing to waive commission fees and can normally provide you with a more personalised service.

Take, for example, exchanging pounds into euros, say the current market rate - or Spot rate as its known - for GBP/EUR is 1.2711.

In other words, each pound would buy you 1.2711 euros in the spot markets.

And continuing with the example above let us assume you wished to make an exchange from the U.K to Europe, of 250,000 pounds.

Since you cannot access the sport market directly you have to go through a bank or a broker.

An average bank rate would be around 1.2411, whilst with an independent broker you could probably achieve a rate of 1.2616.

Therefore, going with an independent broker would mean you would get 315,400 euros for your 250,000 pounds, whilst with a bank you would only get 310,275, which is a difference of 5,125 euros; and that is without including any additional transfer charges the bank would probably charge on top.