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Wealth Management: Foreign Currency.

01.03.10

By Cherry Reynard
 
Working in another country can throw up all kinds of currency risks. Here Cherry Reynard explains how to cope with exchange rate fluctuations and what to do when your new currency is a volatile one.

The equity markets may have been the most obvious ­victim of the ongoing economic turmoil, but for lawyers posted abroad currency fluctuations may have proved painful. In 2009, the pound moved from $1.45 (93p) to $1.61, leaving anyone who hadn’t taken steps to manage their currency risk up to 11 per cent worse off.

For those who moved to the eurozone, the situation was even worse. But how can lawyers protect themselves against currency risk when they take on foreign ­placements? The growth of Asian markets has hastened ­redeployment strategies at many firms.

The impetus is no longer the oft-quoted ’Shanghai, Mumbai, Dubai or goodbye’, but lawyers are instead keen to move to areas of higher growth or greater opportunity. The tax changes in the UK are also sending people in search of more ­benign regimes, where their talents may be, if not better appreciated, at least better remunerated.

But this can leave lawyers open to currency risk, which will arise whenever income is in one currency and liabilities - including everything from mortgages to grocery shopping - are in ­another. The first and most ­important area of currency risk is on salary or profit share. In 2009, being paid in euros was a ­significant advantage if expenditure was in pounds and for example, but being paid in pounds, ­incurring eurozone expenses could produce a ­significant drop in living standards.

Sterling loss
This may happen if someone is posted abroad, or if they are working for the UK branch of an ­international law firm and their firm does not equalise their salary or profit share. This can be a particular issue for UK-based partners of US law firms, whose profit share is often paid out in ­dollars. It is always worth checking what a firm will and will not do to help mitigate currency risk. If there is a firmwide policy in place, exchange rates are likely to be better because partners will benefit from bulk buying.

There are also a number of situations in which lawyers may have to transfer a lump sum. This may be for the deposit on a rental property, for cars, school fees or for buying a house. Equally, there may be money to repatriate from a ­foreign posting that has perhaps been invested while abroad. These one-off transfers may be even more exposed to currency risk.

In some years this won’t be a problem. Currencies can have long periods of low volatility, but it has been an important issue during the financial crisis of the last two years as worries over the UK’s economic strength and whether it is equipped to service its burgeoning public debt have weakened sterling. James Hickman, managing director of currency specialist Caxton FX, says: “The ­sterling depreciation has been significant, particularly against the euro. Anyone earning in euros and shipping them back to the UK has had a fantastic year, but those in the opposite situation have had a dreadful time. Their salary has ­effectively been depreciating.”

The weakness of sterling versus the dollar has not only had an impact for lawyers transferring to and from the US, but also for those posted to countries whose currency is pegged to the dollar, which includes the Indian rupee and most Gulf currencies.

The past two years have been exceptional, but currencies are always ­considered difficult to predict, even in benign environments. This ­unpredictability has been amply illustrated by the fluctuations in the eurozone and Japan this year. Few would have predicted the euro would come under such pressure from the weakness of Greece. Equally, few would have predicted the ongoing strength of the yen in the face of entrenched deflation.

The certainty principle
For lawyers expecting a certain level of salary, relying on the vagaries of the market each month is unlikely to be a ­workable solution. Although they may win some months and lose on others, if they need to pay a ­mortgage in one ­currency and find their salary fluctuating ­because of exchange rates, ­certainty may be more ­important than securing the best long-term rate.

There are a number of options available. Currency transfers can often be arranged through banks with an international franchise, but this will tend to be a more expensive way of doing things. For ’spot’ transactions, ­customers generally pay through a direct fee and/or through the exchange rate. Specialist currency brokers will usually offer lower fees and better rates - ­sometimes by 2 percentage points or more. They deal in bulk and will tend to offer better exchange rates and lower fees the more currency is exchanged.

The difficulty is that foreign exchange is prone to attracting the rougher end of finance. Foreign currency brokers do not have to be FSA-regulated, though the best ones will be. They will have to be regulated from 2012, but during the interim period they can operate without having the required permissions.

Exchange rates can vary enormously and finding the best rate can be time-consuming. Many currency exchanges will charge no commission and make up the difference on weaker rates. Hickman says: “You can compare rates on any number of sites. Bloomberg, Reuters or the FT will all quote the interbank rate and all exchange rates are derivatives of that rate. It’s simply a case of shopping around to find the best company to do that transaction.”

Securing the best rate may be a good idea, but it will not protect against any significant fluctuation in the market in the future. Currency advisers and more sophisticated banking groups will offer a number of ways to ensure an income stream is not vulnerable to currency depreciations. Hickman says: “The easiest way to hedge currency is with a forward contract. If you know that you’re being posted to the US, for example, you can agree a rate in US dollars at which you’ll exchange money. This can usually be arranged two or three years ahead and means that you can draw down on a monthly basis. It means you’ll go out on one salary and know that it’ll remain the same for the duration of your posting.”

Ups and downs
The downside is that if the currency appreciates, the exchange rate has been fixed at a lower rate and there is an opportunity cost. As Hickman says, there are some situations in which people would be better off not doing anything. However, forward contracts will fix income at a set level and are usually ­inexpensive to structure. For most brokers it will generally be no more ­expensive than exchanging at the spot rate.

Options are a more complex and expensive transaction, but do allow some flexibility. Hickman says: “These give the option to buy, but not the ­commitment. With a forward contract you’re in a contract to deliver sterling, but if you buy an option you can let it lapse. It’s a means to limit the downside while still taking advantage of the upside.”

Options tend to have a fixed fee and the investor can determine where they want to draw the line according to their risk tolerance. For example, they can buy an option to ensure that their salary will not fall below a certain level. Or they can buy an option to ensure that their expenses do not rise above a certain level. Elisabeth Dobson, head of private clients at foreign exchange broker Worldfirst, says it is about securing a “worst case rate”.

Specialist advisers can help work out an end-to-end structure for a foreign posting. Dobson says: “Specialist advisers can work out your currency exposure over several years and offer options.” Scale matters, and the more you exchange, the lower the rate you can expect. Dobson adds: “You’ll get better access to products and even spot rate transactions will have a better rate. Higher volume trades will tend to have no commission and reduced transfer fees.”

Fees can be an issue, particularly for those making regular transactions. Hickman says: “Transfer fees can really add up. If you exchange each month’s salary at £40 per transaction, that’s a lot of money over a year. Plenty of brokers now don’t charge transfer fees.” Again, the key is to do some research on rates and fees.

The hedge of reason
In general, it is relatively easy to hedge mainstream currencies. Dobson says: “Currencies such as the Hong Kong dollar, US dollar or euro are vanilla. Hedging should be cheap and relatively straightforward. The difficulty comes not necessarily in currencies that are obscure, but those that are particularly volatile because options are priced on volatility.” Dobson gives the example of the South African rand, where it would cost more to structure options because of its volatility. Lawyers posted to such regions will therefore have to pay more for managing their currency risk.

Currency fluctuations will also impact on investments. For example, the FTSE World Europe ex UK index generated a return of 51.85 per cent in euros for the five years to 2 February. The same index would have generated a return of just 6.4 per cent for sterling-based investors. The strength of the yen was also an important factor in the weak performance of UK-based Japanese retail funds last year, which fell 3.1 per cent on average compared to a return of 17.3 per cent from the Nikkei. Although most investment managers would argue against limiting the diversity of a portfolio on the grounds of currency ­considerations, they cannot be ignored entirely.

Bill O’Neill, chief strategist at Merrill Lynch Wealth Management, says: “When we’re dealing with private clients we’ll always try to base the majority of their investments in their home currency. They should only take currency risk on investments where they can’t get the equivalent in their home currency. Even in these cases it should be hedged. For all our private clients, we’ll have a dollar-based programme or a sterling-based programme as appropriate.”

In general, few fund managers will hedge currency on their funds, but it is becoming more common where there have been significant fluctuations. Rob Burdett, joint head of multi-manager at Thames River Capital, says: “Companies such as GLG are now offering hedged and unhedged share classes in Japan and leaving it to the investor to make the decision. It’s been done more in Japan, but it’s also happening in a number of US funds. Findlay Park, for ­example, has done the same thing. When the yen swung wildly in the late 1990s there was quite a lot of hedging, but ­currency is one of the hardest things to get right and most managers believe that it’s simply not their area of expertise.”

Lawyers working abroad will also have to consider longer-term issues such as pension provision. Most will not want to halt contributions during their time abroad, which brings another area of currency risk. The recent changes to the UK tax rules will have proved disadvantageous for many high-earning lawyers and, where possible, they will want to ensure that their pension payments ­remain in another tax jurisdiction. If they have an offshore pension, this will raise currency issues at the time of encashment and, again, lawyers may want to hedge this exposure.

Credit cards raise another issue for lawyers posted abroad on day to day ­expenditure. Using UK-based credit cards will often have poor rates and charge per transaction. A number of banks offer credit cards specifically for ­foreign transactions that will exchange at wholesale rates and not charge fees. These will be more expensive to use in the UK, so it can be worth having ­separate cards.

Gamblers may want to bet on the rise of one currency versus another, but for those who like to know what they are getting at the end of every month, some form of hedging will be appropriate. Currency risk can crop up in all sorts of places - salary, pension, home-buying - and with no end to economic volatility in sight, an awareness of currency issues is vital.

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