Sometime ago I mentioned the following when discussing Euro mortgages. Which I repeat here, adapted for Euros as a few people were interested in the concept. It is a little long, but maybe of use to some...
This answer is from Dave, a close friend of mine whose occupation is Foreign Currency Risk Management.
I used to get asked on a surprising number of occasions by financial directors of our clients if it was possible to borrow money in Euros to fund their latest ventures in the UK. Why? Because at the time Euro interest rates were lower than in the UK with Euro base rates being 2% at the time (this was before the Bank of England's subsequent reductions).
Of course it is possible to borrow in a currency that is not native to your business...
Additionally, of course you can end up suddenly assuming a massive foreign exchange exposure between GBP and EUR.
You need to borrow GBP 100,000.00 for a 1 year for new factory machinery.
You instead borrow EUR 146,000 paying 2% excluding credit margin, and convert it to sterling at today's rate of 1.4600 to the pound giving you your GBP 100,000.
Then in a year's time you need to repay EUR 146,000 plus interest meaning a total of EUR 148,920.
So from GBP you need to find EUR 148,920. If you are 'lucky' then the GBP/EUR rate of exchange will not have moved over 12 months. If this is the case then you have indeed paid a low interest cost in comparison with what is available in the UK and you repay GBP 102,000.00 meaning you achieved borrowing costs of 2%, well done.
If you are 'very fortunate indeed' the GBP/EUR will have risen to say 1.5500 and then this will cost you GBP 96,077.42 to repay the loan, less notional than you borrowed!
If you are 'less fortunate' the GBP/EUR rate will have fallen to 1.4000 and then this will cost you GBP 109,500.00 to repay the loan, an 'interest' payment of 9.5%.
The borrower is doing nothing but pure speculation, by creating an exposure in a currency/asset that he would not normally use in day to day business.
Is it possible to protect yourself against currency movement? Yes, of course...If you purchase EUR today but forward dated the contract for delivery in one year's time the rate received would be approximately 1.4183, meaning you would need to find GBP 105,000 to repay the loan, i.e. the same economic cost of borrowing GBP 100,000 for 1 year. The forward rates offered by banks simply mean that the bank buys the EUR today and holds it on deposit and then re-calculates the economic cost of forgoing the normal return on GBP in the UK.
There is no way round this. Believe me I have tried. The only cure for hard drugs is cold turkey. I have worked in currency management for a number of years and I am continually surprised by the money illusion suffered by many in high positions.
I used to have a customer who ran the accounts of a large famous name brand who used to do just this type of speculation every year. He had gotten away with it due to low currency fluctuation. One day he will be found out. The problem is that his company rules made no restriction because nothing had gone wrong to date. Amazing. This is basically playing Enron with currencies.
If this Euro mortgage catches on, don't touch it with a bargepole unless you are paid in Euros.
Secondly, I was then asked about investing in foreign currencies. To that I said that if you had actually decided to go ahead and this is a big if, then I suggested using spread betting for the following reasons -:
I do not work for a spread better so please don't think I am saying this for any personal benefit. It's just that spread betting makes the perfect synthetic trade and is accessible to all. I also see no reason why you couldn't keep a trade open over many months or years. You could also use spread betting to completely hedge a real forex position. For example if you had a sum in Euros which you wanted to protect you could do it notionally by doing the equal and opposite trade on a spread bet against GBP.
It was then suggested by Ah-so, that using spread betting was also an excellent way to lose your shirt.
So I now want to explain why this is not the only way to think about spread betting.
Yes, spread betting will allow financial illiterates to leverage themselves silly and lose lots of money.
However, as an alternative to say buying EUR10 grand and crucially one assumes that you actually have the money to buy that 10 grand in the first place, then spread betting can be used as a very effective and efficient tool. Economically it will offer you nothing other than a synthetic trade. It is only if you don't understand what you are doing can you lose significant amounts. Its only if you are not already considering investing EUR 10 grand that you can lose differently than the real investment.
Its actually this lack of understanding that is the problem, not spread betting itself.
Let me try and explain with an example.
Assume that today's EUR/GBP exchange rate is 0.6848, (this ratio is the most common quoted currency pair, the one used by the markets). It means that one EUR is worth GBP 0.6848. The inverse of GBP/EUR at 1.4603 which you may see quoted at the bureaux de change. Let's also assume that the bid and offer rates are the same at a bank and a spread better, which they are not.
Go to a bank and buy EUR10,000.00, this will cost you GBP 6,848.00 in exchange.
Possibility a) After 12 months the rate rises to EUR/GBP 0.7444,
EUR 10,000.00 is now worth GBP7,444.00 meaning you have made GBP596.00.
Why? Because the EUR, the asset you have invested in, is now worth more than when you bought it.
Possibility b) After 12 months the rate falls to EUR/GBP 0.6444,
EUR 10,000 is now worth GBP6,444.00 you have lost GBP404.00.
Why? Because the EUR, the asset you have invested in, is now worth less than when you bought it.
Buy 1 pound per point at (spread bet quote) 6848.
Possibility a) After 12 months the rate rises to EUR 0.7444 your spread bet quote will rise to 7444 and you will have made GBP 596.00.
Why? Because the index has moved up by 596 points and you bet 1 pound per point.
Possibility b) After 12 months the rate falls to EUR 0.6444 your spread bet quote will also fall to 6444 and you will have lost GBP 404.00.
Why? Because the index has dropped by 404 points and you bet 1 pound per point.
In both cases the impact to you is the same.
The figures work very conveniently because I have chosen to invest EUR 10,000 and the index is quoted to 4 figures, but investing in any currency or indeed any share index can be worked out in the same way, by working out what bet per point will be required to simulate a real investment.
There is no hoodoo to this, the problem of course is simply that people buy 1 pound per point and do not realise that they are actually doing the equivalent of investing EUR10,000.
I hope this is of interest to people and I haven't made any silly mathematical mistakes.
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