An increasing number of travel companies are experiencing intensifying pressure on their bottom line due to the weakness of sterling.
In particular, tour operators who have not hedged their foreign exchange rates effectively are feeling the financial strain.
Cost margins from foreign exchange rates are creating considerable overheads for many companies. Overseas accommodation costs are often paid in euros or dollars, despite being advertised in sterling. Add this to on-site staff costs and fuel prices for transfers – commonly paid in local currency – and travel businesses may find themselves footing the bill for customers’ holidays.
Although many overheads – flight costs, UK sales staff, rent costs, agents’ commission and marketing – are usually payable in sterling, it seems more and more risks are presenting themselves as some travel businesses ignore the plight of the pound.
So how can a travel business optimise its protection against foreign exchange (FX) risk?
At one end of the spectrum a business could do nothing, leaving its FX exposure as it is; at the other end, it could hedge 100%. Both extremes create their own risks and, in practice, businesses may choose a position somewhere between the two.
Alongside currency fluctuations, the decision may also be affected by uncertainty about the amounts of each currency required.
A travel company will typically consider a range of factors affecting their ability to respond to foreign exchange movements when determining their hedging strategy – for example, their ability to adjust pricing in their brochures or online or absorb FX movements in profit margins. Many will also consider the potential reaction of competitors.
In many cases, businesses decide to risk a portion of their margins to benefit from the protection afforded by hedging with the aim of achieving a target FX level and to protect against negative currency moves.
What does this mean in practice? The high level of volatility in the currency markets has led some to question the wisdom of forward contracts, in which a company agrees to purchase or sell a set amount of foreign currency at a specified price for settlement at an agreed date.
Even small time delays in FX execution can have a significant impact on rates. For example, a daily trading range of 400 basis points [or 0.4% of a currency unit, 1 basis point of sterling would be 1p] represents a potential gain or loss of up to US$400,000 on a £10 million exposure of UK pounds to US dollars. It means companies may need a more flexible (but not necessarily more complex) approach to managing foreign exchange.
As a result, we have seen a marked shift in behaviour among travel clients. There has been a concerted move away from the traditional reliance on relatively inflexible spot and forward contracts, towards greater use of a mix of FX options together with spot and forward FX contracts. Many travel firms have been targeting a euro level of euro1.15, for example, and using a combination of FX options and forward contracts to achieve this.
Managing currency risks has always been complex and challenging, but the recent rise in volatility has compounded the difficulty. With major economic turmoil and resulting volatility in two of the UK’s largest travel markets, the US and Europe, managing FX risks has never been more important.
Mike Saul is head of hospitality and leisure at Barclays Corporate