Foreign Exchange (FX) markets have been significantly impacted by the COVID-19 pandemic, with Sterling in particular falling 15% against the US dollar since the beginning of 2020. The resulting volatility has created a challenging valuation environment unseen for many years. During such times, it becomes crucial for end users of FX products, including corporates and commercial banks, to understand the impact on their balance sheets and the risks to valuations and financial reporting associated with increased FX market volatility. In doing so, these end users will be in a much better position to maintain the value in their portfolios.
Below we have explored the impact of COVID-19 on key FX markets, covering each of the main product areas in turn from spot markets through to option markets. Particular emphasis is placed on the greater diligence that needs to be performed around reporting valuations and hedging construction. We note, however, that derivative markets have potentially opened up a number of risk management opportunities like competitive financing through the use of cross-currency basis swaps and possible benefits from hedging with options highlighting potential value upsides for end users.
Volatility in the GBP/USD rate has reached its highest levels since the Brexit Referendum in 2016, increasing by more than 250% compared with the start of the year (Graph B). Similarly, for other major currencies, volatility against the US dollar and against each other spiked during the second half of March.
This combined with a major weakening of Sterling against the US Dollar and Euro (Graph A) will have a large impact on the valuation of assets and liabilities for UK companies with significant exposures in these currencies. Additionally, the high FX volatility is likely to cause substantial intraday valuation movements, further highlighting the importance of strong diligence around valuation cut-off times. This should drive the adoption of a consistent approach mitigating the operational impact.
Graph A. Spot rate evolution of major currencies (Source: Refinitiv Datastream)
Graph B. GBP/USD volatility evolution (Source: Refinitiv Datastream)
FX forward curves represent the pricing of contracts exchanging currencies in the future, so should be interpreted as the cost of hedging future currency receivables, rather than as an accurate prediction of where exchange rates will be in the future. However, bearing that in mind, it can still serve as an informed reference point as to the market's perception of where exchange rates will be in the future.
Not surprisingly, between the year-end and the beginning of April, Sterling shows a significant fall in value against the US Dollar across the curve (Graph C). However, the shape of the curve has also changed. At year-end the market was expecting Sterling to strengthen against the US Dollar in the 6-month to 2-year period and beyond (although liquidity drops beyond 2 years). Winding the clock on to early April and the curve for the same 6-month to 2-year period is essentially flat suggesting that interest rates will remain low as the UK endures a slow and prolonged recovery. The GBP/EUR forward curve shows an overall repricing relative to year-end, however the shape of the curve is broadly similar with Sterling falling relative to the Euro at both year-end and early April highlighting the continued uncertainty for the UK economy after Brexit. Yen and Euro reprice relative to the Dollar but have broadly similar curve shapes across the period.
Graph C. Evolution of majors forward curves (Source: Refinitiv Datastream)
FX Forward contracts are the mainstream products for corporate and commercial banking hedging strategies against FX fluctuations. The current increased volatility in the FX markets is expected to have a significant impact on the valuation of these contracts; in particular as shown above the 2Y GBP/USD forward rates dropped by around 15% in the third week of March but recovery since then has been weak with rates still trading around 10% lower than the start of the year.
In general, the weakening of Sterling will have a large impact on the valuation of all GBP FX forwards, including USD and EUR crosses, used for hedging assets and liabilities in foreign currencies.
Additionally, the high FX volatility can result in substantial intra-day movements in the valuation of FX derivatives and foreign currency assets and liabilities. This emphasises the importance of strong diligence and consistency around valuation cut-off times and the performance of sensitivity analyses to identify the areas where this increased volatility can have a large valuation and hence operational impact. The treatment of any derivatives under hedging arrangements should also be revisited.
Companies will now need to interpret the repricing illustrated in the forward curves, particularly the flatness of Sterling (Graph C) in the context of their underlying exposures as this may have implications for the volume of hedging needed, and determine whether the cost of hedging needs further consideration and is still consistent with their policy.
The cross currency basis represents the amount by which the interest paid to borrow one currency by swapping it against another differs from the cost of directly borrowing this currency in the cash market. It exists because FX derivatives, including forwards and cross currency swaps, involve an actual transfer of currency. In line with the overall trend in the FX markets, the basis adjustment for cross-currency swaps has become more volatile (Graph D). During the first half of March, basis spreads of major non-USD currencies decreased further, highlighting market counterparties efforts to secure USD funding.
Graph D. Evolution of major cross currency basis swaps (Source: Refinitiv Datastream)
In general, the cross-currency basis is a measure of US Dollar shortage in the market. The more negative the basis becomes, the more severe the shortage. The basis spread is a key component of the pricing and valuation of FX instruments. Consequently, strong diligence should be exercised around the reliability of the source of valuation inputs, including basis sourcing, on cross currency swaps to enable robust valuation reporting and mitigate any operational impact of mispricing.
Volatility in the basis is generally unwanted but accounting standards in many jurisdictions allow for cross-currency basis in hedging instruments to be removed and accounted for separately to minimise volatility in the P&L caused by changes in the basis spreads. Given the current high volatility in the cross-currency basis, companies with significant cross-currency hedges should review their accounting treatment to ensure unwanted volatility does not impact on their P&L where possible. Access to curves that include and exclude the basis will allow them to quantify its impact.
Generally cross currency swaps are used to hedge long-dated contractual exposures, such as bonds or loans issued in a foreign currency. Given the ongoing volatility and repricing of the basis, companies should also consider whether there are now opportunities to benefit from the basis. For example presented through synthetic financing. Thus, whether it is advantageous to issue debt in their domestic currency vs an equivalent issuing and servicing debt in a foreign currency followed by a cross-currency swap transaction. As the latter incorporates the impact of the relative basis between the two currencies it could present opportunities to some companies for lower-cost financing.
Further for US Dollar-funded investors, negative basis can work in their favour when they hedge currency exposures i.e they can arrange to receive the basis. Thus through hedging foreign currency exposure, they can lend out US Dollars today and receive it back in the future, earning additional cross-currency basis spread on top of the yield of their foreign investments.
Companies often avoid using options to hedge exposure given the upfront premium involved. This will, generally, have become more expensive given the rise in implied FX volatilities.
To get around having to pay upfront premiums we often observe end users of options deploy a combination of options to create a so-called synthetic forward which is similar to a conventional forward in terms of offsetting underlying currency exposure. However, by changing the combination of strikes and maturities, synthetic forwards not only mitigate FX movements but could also allow for some benefit from the FX movement as opposed to a standard forward.
This will be either costless or near to costless. For instance, the premium paid for the currency call option will be offset by the proceeds from the sale of the put option or vice versa. Volatility surfaces for calls and puts as illustrated by Graph E can be used to determine that out-of-the-money (OTM) puts have become more expensive than equivalent OTM calls as the cost of insuring downward movement in Sterling has become expensive, this may open up opportunities to exploit the rise in put premiums relative to call.
In general, though, companies with FX options on their books now need to scrutinise their sourcing and reliability of market data used as key inputs in valuation, including the sourcing of forward FX rates and volatilities to ensure risk management effectiveness and financial reporting compliance.
Graph E. GBPUSD call & put option volatility (Source: Refinitiv Datastream)
If they haven’t already, they should consider doing the following:
Scrutinise the reliability of market data used as valuation inputs.
Review FX exposures and identify where the valuation and operational impact of market volatility is most significant.
Think about the impact of potential scenarios and consider whether existing FX hedging strategies are appropriate or need revisiting.