What Are Leads and Lags?
- Leads and lags refer to the timing of payments on international agreements to take advantage of exchange rate changes.
- Entities that have control over the payments may find it advantageous to delay or accelerate payments based on anticipated currency changes.
- Not all currency-rate events and be adequately forecast, but those that can are usually tied to political events.
Understanding Leads and Lags
When a corporation or government entity has the ability to control the schedule of payments being received or made, then that organization may opt to pay earlier than or delay the payment later than scheduled.
These changes would be made in anticipation of capturing the benefit from a change in currency exchange rates. These dynamics hold true both for small and large transactions. If a company in one country were about to acquire a corporate asset in another country, and the target company's country currency was expected to decrease in value relative to the acquiring company's country, then delaying the purchase would be in the interest of the acquiring company.
A strengthening of the currency being paid out would lead to a decreased payout for the entity in question, while a weakening of the currency would lead to increased costs the longer the payment was delayed. Because it amounts to a timing strategy, leading and lagging implies risks. A lack of proper execution may result in an unfavorable outcome.
When a business has an expected foreign exchange transaction as the result of a deal, it may need to buy or sell a certain currency. If the company believes the currency may move in a certain direction they may choose to speed up the transaction or delay it to take advantage of the potential outcome. Normal price movement from supply and demand between countries can be very difficult to forecast, but certain political events may have a known timeline and can be more easily anticipated (consider the UK's Brexit vote as an example).
Accelerating a transaction is known as "leading" while slowing it down is known as "lagging." For example, if a U.S. company has agreed to buy a Canadian asset then it will need to buy Canadian dollars and sell U.S. dollars to complete the transaction.
If the company believes the Canadian dollar is going to strengthen against the U.S. dollar they will accelerate the transaction (lead) before the price of the asset increases in U.S. dollar terms. Conversely, if the company believes the Canadian dollar will weaken, they will hold off payment (lag) in the hope the asset becomes cheaper in U.S. dollar terms.
Leads and Lags Risk
There are risks with leading and lagging in that the move in the currency may not go as expected. For example, if the company that is buying the Canadian asset chooses to hold off payment because it believes the Canadian dollar will weaken and, before making the payment, the Bank of Canada (BoC) unexpectedly raises interest rates then the Canadian dollar will strengthen making their decision to hold off detrimental. For this reason, some companies will choose to make part of the payment at the time of agreement and wait to pay for the remainder.