Discussion Many firms attempt to manage their foreign exchange exposure through hedging. Hedging requires a firm to take a position—an asset, a contract, or a derivative—the value of which will rise o

Mini-Case Brexit and Rolls-Royce1

Brexit and Rolls-Royce

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Rolls said it “remains committed to the UK where we are headquartered, directly employ over 23,000 talented and committed workers and where we carry out a significant majority of our research and development. The UK’s decision will have no immediate impact on our day-to-day business.”

—“‘Business as Usual’ for Rolls-Royce as It Remains on Course despite Brexit,” The Telegraph, June 28, 2016.

The decision by the people of the United Kingdom to leave the European Union (EU)—Brexit—in June 2016 raised many questions over the future of many of the UK’s multinational firms. One firm in the limelight was Rolls-Royce, one of the premier aerospace engine manufacturers in the world. Rolls was one of Britain’s major exporters, credited with roughly 2% of the country’s annual exports. Following Brexit and the sharp decline in the British pound sterling, analysts were attempting to gauge how the EU exit would alter the company’s business and how the company’s leadership was likely to react.

The Business and Currency Hedging

Rolls-Royce Holdings PLC is a UK-based multinational group that designs, manufactures, and distributes power systems to the aviation (civil and defense), marine, nuclear, and other industries.2 It is listed on the London Stock Exchange (LSE: RR) and is a member of the FTSE 100 index. It is the second largest manufacturer of aircraft engines in the world, and closed 2015 with £13.725 billion in revenue and £0.084 billion in net income. In recent years nearly all of its profits have come from the aerospace sector.

2 Note that Rolls-Royce Automobiles is not a part of the company, having been sold off in 1973. Today the automotive unit is owned by BMW of Germany.

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But Rolls had a serious, long-term, structural currency problem. Although it was based in the UK, with most of its manufacturing operations in British pounds, its global sales were dominated by the U.S. dollar. This reflected the location and identities of its major customers like Boeing and Airbus. As illustrated in Exhibit A, this structural currency mismatch meant the company had a significant operating exposure problem, earning primarily U.S. dollars when paying out British pounds and euros. (Because many of the pieces, parts, and subcomponents used by Rolls were sourced from Continental Europe, the euro was a net short position for the company as well.) Since many of Rolls’ sales programs were lengthy, often between three and six years in length, this long-dollar position was not only large, it was relatively predictable over time.

Exhibit A Currency Structure of Rolls Royce’s Global Business

Figure A Full Alternative Text

The Hedging Program

“Rolls-Royce operates in a number of very long cycle businesses and we therefore have a long-term hedging program to provide a degree of certainty to our cash flows going forward,” Rolls-Royce spokeswoman Jane Terry said in an e-mailed statement.

—“Rolls-Royce May Rue Long-Term Hedging Decision as Pound Plunges,” Bloomberg.com, Mar. 15, 2013.

Rolls, like most multinationals, values predictability of cash flow. In an attempt to increase the predictability of British pound proceeds from sales, given the fluctuations of exchange rates, Rolls in 2012 had started a large—more than $20 billion—long-term currency hedging program, some of it more than six years in duration. The majority of the hedge program locked-in U.S. dollar revenues at an average of $1.60 per pound, using primarily forward contracts, for six years into the future.

Exhibit B presents Rolls-Royce’s currency derivatives program status as of December 31 for the previous two years. Note that the predominant value is the amount of U.S. dollars sold forward—mostly in exchange for British pounds sterling, but some also for euros and other unnamed currencies.

Exhibit B Derivative Financial Instruments Related to Foreign Exchange Risks

Currencies Sold Forward Currencies Purchased Forward

Sterling (millions of £) US dollars (millions of £) Euro (millions of £) Other (millions of £) Total (millions of £)

Sterling 0 383 0 221 604

US dollar 18,869 0 1,552 902 21,323

Euro 2 76 0 125 203

Other 131 12 143 2 288

At December 31, 2015

Currencies Sold Forward Currencies Purchased Forward

Sterling (millions of £) US dollars (millions of £) Euro (millions of £) Other (millions of £) Total (millions of £)

Sterling 0 429 0 199 628

US dollar 16,659 0 2,014 938 19,611

Euro 150 61 0 185 396

Other 167 9 114 10 300

At December 31, 2014

Source: Rolls-Royce Group plc, Annual Report 2015, p. 143.

As is the case with unpredictable markets, the hedges had not always proved profitable when viewed in hindsight. In the summer of 2014 the pound began to fall against the dollar, a favorable movement for Rolls that the company could not fully enjoy given its lock-in hedge program. As is always the case, locking in a guaranteed rate meant that when the exchange rate moved in the company’s favor, its protection would prove to be a cost, as it could not enjoy the favorable movement. Unfortunately, the pound’s slide against the dollar had continued into 2016.

Publicly traded companies like Rolls must continually worry about short-term market movements while keeping long-term competitiveness in their sights. Although the company believes its long-term hedging program is in the long-term interests of the company, there will always be periods in the short-term that make the program appear to be a mistake (reflected in short-term share price movements).

Exhibit C attempts to provide some longer-term perspective to the challenge Rolls faces. The exchange rates that matter the most, the dollar and euro against the pound, show varying periods of relative strength and weakness over the past 25 years. It is apparent from Exhibit C that the pound has enjoyed a long period of relative weakness against the dollar and euro. But the recent Brexit vote seems to have pushed it down to a level not seen in the past quarter-century against the dollar, as well as approaching the historical lows versus the euro.

Exhibit C Long-Term Exchange Rates of the Dollar, Euro, and Pound

Figure C Full Alternative Text