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Protecting SFP values

Course: Farm finances | Last Updates: 12th October 2015

Jake French
Biography >>

Since the SFP was introduced on 1 January 2005, the value of the euro against the pound has fluctuated by about 25%, as can be seen from the graph. 

Such volatility means that the true value of the annual SFP to UK farmers has varied wildly. For example, the value of a €100,000 SFP paid in sterling has ranged from £67,770 in 2006 to £90,930 in 2009.

A 10-year chart of the euro/sterling

As an EU-backed scheme the SFP is calculated in euros but recipients can choose to receive their payment in sterling, as 95% of UK farmers do. 

The exchange rate used is that at 1:15 GMT on the last trading day of September, which means that the value of payments for most farmers is being dictated to by the exchange rate at one particular time on one particular day of the year, which makes no sense. 

The table below shows the historic payment rates, set by the European Central Bank, which have been used in SFP calculations.  

Historic SFP rates 
2005 0.68195 (1.4664)
2006 0.67770 (1.4756)
2007 0.69680 (134351)
2008 0.79030 (1.2653)
2009 0.90930 (1.09997)
2010  0.85995 (1.1628)
2011 0.79805 (1.2530)
2013 0.83605 (1.1961)

Why should you hedge your SFP?

By electing to receive your SFP in sterling you are leaving the value of your payment to chance. That is because from the time of application in May to the payment window which runs from 1 December to 30 June, there may be large fluctuations in the exchange rate.

Electing to be paid in euros gives the claimant the chance to protect the value of their payment through a relatively simple mechanism by locking into a euro exchange rate on a currency contract at any time during this period rather than having the rate fixed for them by the EU on the last trading day of September.

What proportion of farmers hedge their SFP payments?

About 5% in the UK choose to take their payments in euros. While there are no overall figures to show what proportion of these then hedge the value of teir payment, the proportion is growing because it gives them much greater certainty and enables them to budget accurately. Even those who take a sterling payment can take some measures to protect the value of that payment.

What strategies can be used to protect SFP payments?

1) Tick the sterling box on the SP5 claim form and book a contract for difference (CFD) through your bank or foreign exchange broker. This is a form of forward contract which ultimately pays the difference between the rate you choose when taking the CFD and the rate on a specific date, usually the end of September when the SFP rate is set. 

These transactions will be executed by a bank or broker who will close out the trade for you at the appropriate time. The CFD represents the difference between the rate prevailing at the time you book it and that when you close it out. You effectively end up with either a net profit or loss, so either you will pay your bank or broker the difference, or they will pay you. Either way, it allows you to fix a rate with which you are happy.

However, there are derivative products, which tend to be more expensive, more complex and more risky than other routes to hedging – your losses are magnified if the market moves against you and can lead to losses exceeding your initial outlay. Seek advice to see if this is appropriate for you.

2) Tick the euro box on the SP5 claim form and fix the exchange rate at any time before you receive your payment using a forward contract through a foreign exchange broker or a bank. 

This allows you to purchase/sell your currency now, at the prevailing rate, with settlement for the transaction happening on a pre-determined date up to 12 months ahead. 

You’ll be asked to provide a deposit of between 5-15% of the value of the transaction as security payment to book the transaction. You’ll also be required to send the remaining balance on the agreed pre-determined date in the future. 

This is effectively a “buy now, pay later” scenario, allowing you to lock in a rate, even if you don’t have all your funds available. Should the exchange rate worsen you will not be affected because you have fixed your rate. 

However, it is important to remember that if the exchange rate improves, you will not be able to alter your contract.

If you don’t want to do so on the whole SFP amount you can lock in the rate on a percentage of it to begin with and convert the rest at any time up to or after the payment date. 

3) Tick the euro box and if you have access to enough sterling funds and want to convert all or part of them straight away, you can enter into a spot contract. 

This is essentially a “buy euros now, pay now” option and is available online or over the phone depending on the amount you are looking to transfer.

4) Tick the euro box on the SP5 claim form – then, once you receive your euros, you can decide when you would like to convert your payment into sterling, at a time (and hopefully a rate) that best suits your business. 

Some farm businesses have interests in Europe and have euro bills or payments to pay or make, so they like to receive euros. However, using this method you will still be carrying an exchange rate risk. 

If you are looking to achieve a specific rate or you have strong views about future exchange rates you can arrange an instruction to target a specific rate of exchange. 

The bank or broker then monitors the markets on your behalf and if it reaches your predetermined exchange rate, your currency is bought or sold automatically. 

When and how should you hedge your SFP?

Everyone is different, so the answer to this question depends entirely on your appetite for risk. My advice would be: don’t get too greedy, keep it simple and don’t overcomplicate matters. 

Set a target rate that is realistic and you are happy with, then when the exchange rate hits that figure, book an amount which corresponds to the proportion of your SFP you want to protect.  

If, for example you decide to hedge 50% that will give you some protection, some certainty and time to re-evaluate. Once you have made the decision and implemented the forward contract, you can forget about it, knowing what sterling amount will reach your account.

When taking out any forward contract it is advisable to set a “stop loss”, the level at which your contract will be closed out if the exchange rate goes beyond a pre-determined point. As its name suggests, this limits your risk to a pre-set amount should the position move against you. 

With a forward contract, most brokers and banks will require an initial deposit of 5-10% of the value of your SFP and if the exchange rate moves against your position, they may require cash known as margin calls to make up the difference.  

Deciding to hedge your SFP is no different to selling grain forward, Forward buying inputs such as fuel or fertiliser, or arranging a fixed-rate mortgage. Like these, hedging gives you peace of mind. The important point to remember is that it is not about making money on the transaction but protecting your bottom line against exchange rate fluctuations.

However it is very important to understand the basis of the deal you are doing – is it on an execution-only basis, where you decide at what point you go into the market, or are you getting an element of service or advice?

How do I know if I am getting a good deal?

Banks and brokers make their money in exactly the same way. Banks deal at the interbank rate, the exchange rate at which commercial banks trade currency with each other, usually in amounts larger than £5m. Then they make a margin by selling the currency to customers at a different rate.

A guide to interbank rates can be found on the internet where foreign exchange websites show bid and offer prices. Foreign exchange brokers buy from banks at a very small margin above the interbank rate and, like the banks, make a margin by selling the currency on to customers at a different rate. 

In general, brokers take a lower margin than the banks because they rely on doing a high volume of transactions. The lower the margin between the interbank rate and the broker’s quote, the better it is for the customer, but be wary of accepting either no or minimal margin. Ask why they would give you such a deal. While it might seem good at the time, do you really want to deal with a business that doesn’t make profit? 

Banks sometimes outsource their small and medium enterprise and private client foreign exchange business to brokers because the administration makes it costly for them to handle such business. 

It pays to shop around – with any transaction it is worth getting several quotes for the same business within a short timescale so you can compare what is being offered with the interbank rate. You can check the interbank rate online. 

With any such contract you need a settlement date and because SFP funds can come in at any time within a seven-month window from 1 December to 30 June, it is important to have flexibility on this with your hedging arrangements.

Some banks offer only a narrow window of two weeks either side of the settlement date. Therefore, if you sell your euros for 1 January you will have to receive them between 15 December and 15 January, otherwise the bank will impose a penalty. 

Most brokers tend to be more flexible but always check for this and ask if there are penalties.

Do most farmers who hedge their SFP payments use a bank or foreign exchange broker?

Most use their bank, simply because they have overdraft or loan facilities there, they want to keep the bank manager happy and think that booking foreign exchange deals through a broker may affect their banking arrangement. However, this should not be the case, although remember that using a broker will mean that if you are taking your payment in euro, it is likely to be paid into the broker’s client account unless you arrange otherwise. 

What questions should you ask your bank and broker?

  • How long has the broker been operating – choose one with a few years’ track record and ask other farmers who they use and what their experience has been. 
  • Are they authorised and regulated by the Financial Conduct Authority (FCA)? This is important. Currency broking is a saturated market and there are good and bad operators. All money service businesses must be regulated by the FCA but this not good enough – they should be authorised too.
  • What type of bank account/facilities are needed and how easy or difficult are these to set-up/maintain? 
  • If you use a bank for the transaction and do not already have a euro bank account you will have to set one up with them – check the likely costs and fees.
  • What are the deposit and margin call requirements?
  • What is the basis for the arrangement – execution only or advice service – what level of service?
  • How far is your rate from the interbank rate? Unless you ask, they won’t tell you.
  • Are costs catered for by the rate offered or are there separate fees or premiums?
  • How flexible is your contract – what happens if you do not receive SFP by the expected date? Some contracts allow for bringing forward or rolling-on, but check the cost of this – others will be closed out automatically.
  • Is a deposit required – how much?
  • Will there be margin call costs?

If you use a broker you can ask the Rural Payments Agency (RPA) to forward your payment direct to your broker’s client euro account for conversion. To enable this, you will need to complete form SP13, which you can obtain from the RPA website or your agent. You can also use your own euro account if using a broker.

Is there a minimum size of payment that makes it worth hedging? 

Yes, €50,000 will probably be the minimum amount worth hedging.

What management is required if a claimant decides to hedge SFP? 

The farmer must be able to trust their bank or broker contact, who should guide them through the process, contact them when the target rate is achieved, book a competitive rate, remind the customer when they are to receive the euros and establish where they should be sent. Any other level of service or advice should be clearly set out. 

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