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Thursday, 9 April 2009

A cautionary tale for those holidaying abroad this year

.. but about currency risk. It seems that the Foreign Office are finding their cashed squeezed, particularly for their overseas embassies where many of the costs are paid in foreign currencies. This didn't used to be a problem because the budget was agreed three years forward and the Treasury worried about the currency risk, so they aklways had enough. It seems that in the last budget cycle, the Treasury said they were going to stop the currency hedging and it would be up to the FCO to do the same, wheich after a lot of civil servant bumbling they did, but they didn't hedge all of their exposure, so now they have a problem because their unhedged foreign currency costs have risen but their sterling budget is fixed.

But that isn't the story. A similar thing happened over 20 years ago to a large European state run airline. OK, it was Lufthansa. For many years, Lufthansa bought Boeing aircraft and paid for them in dollars. Being state owned, loss-making and because at the time their was no European manufactured equivalent of the larger aircraft in their fleet, they resigned themselves to the paying for the Boeing aircraft in dollars. After all, much of the non-salary costs in the industry (planes, spare parts, landing fees, fuel) are fixed in dollars and the IATA fare structures were largely dollar based as well. So when a plane was ordered a few years in advance of delivery, the contract was drawn up and settled on delivery in dollars. When it came time to pay for the planes the finance director reported the deutschmark equivalent of the dollars spent and everybody went home happy.

Then one day some bankers paid a visit on the treasurer and suggested that as he had large forward commitments to spend dollars on airplanes he might like to transact a forward purchase of dollars to fix the cost in deutschmarks because there was a general feeling that the dollar would strengthen, ebven though it would be a change from past practice. The treasurer listened to the bankers and fell for their smooth talking, but being a cautious German, he decided that he would only hedge half of the exposure.

I know what you are thinking, but no, the dollar did indeed strengthen and the partial hedge was effective in saving the airline millions of dollars. When the day came to tell the board about the money that had been spent on aircraft, the treasurer accomapnied the finance director to the meeting and explained about the money that had been saved through the hedging strategy.

"But what", replied various board members, "about the unhedged dollars? We have lost millions by not hedging all of the dollars". And they fired him.

Moral #1: Currency hedging is all about deciding where you want to be and fixing that position. There will always be another position that would have had a better payoff.

Moral #2: Germans have no sense of humour. They shouldn't have fired the treasurer, but simply cut his salary by 50%.

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