Multi-year versus rolling FX hedging: What Private Funds need to know

Situation

A USD fund ("Fund") invested in foreign-denominated assets in Europe has an expected holding period of 3 to 5 years. Currency fluctuations over that time horizon can be significant and may cause a material drag on Fund total return.

Private funds invested internationally may use FX forward contracts to hedge against currency movementsD. Due to the rise in U.S. interest rates, currency hedgers receive a better rate for selling developed economy currencies (and buying USD) on the forward market as opposed to the spot market. This benefit, known as the FX carry pick-up, generally grows with tenorD.

The value proposition in this case is attractive, especially absent a strong view on the direction of foreign currencies. The Fund receives additional return and will mitigate exposure to currency risk.

Implementation consideration

Success of the forward hedging strategy relies on managing the economic impact of two unknowns: valuation and date of exit.

Valuation uncertainty is generally handled by executing the hedge in layers or tranches, starting with the initial capital as the first order hedge and then upsizing according to the rise in Net Asset Value (NAV). Alternatively, exit value uncertainty may be handled by utilizing currency options.

Uncertainty about the eventual date of exit, on the other hand, may be addressed by rolling short-dated FX forwards, or by electing a longer tenor that will sufficiently cover the expected holding period and unwinding the hedge early as needed. The tradeoffs are central to deciding between the two. Rolling annual hedges requires less credit or collateral posting but expose the Fund to an undesirable cash event at expiry of the hedge that is not offset by cash flows from the exit. Opting for a conservatively longer tenor would require greater credit to enter into, but will avoid the cash event, assuming the exit occurs prior to the expiry of the contract.

Analysis of alternatives

With an expected holding period of 3 to 5 years for its European assets, the Fund has two strategy alternatives involving FX forward contracts for hedging the realized USD IRR against a weaker euro.

Summary and conclusions

Protection from a lower EUR/USD spot rate is the same for both strategies. However, the strategies differ in three key areas:

1. Alternative 1 has cash inflow and outflows of +$8M and -$7M for years 1 and 2, while Alternative 2 does not.
2. Day 1 credit utilization of Alternative 2 is greater than Alternative 1.
3. In this hypothetical example, the total gain from hedges inclusive of the forward points is also the same for both strategies because it was assumed that the EUR/USD forward points are static throughout the hedge period. In reality the forward points will move, but the volatility is much less than the volatility of the spot FX rate.

As long as U.S. interest rates are higher than interest rates abroad, the forward point adjustment on the hedges will boost IRR. The benefit of longer-dated versus shorter-dated forwards is that this strategy locks the current carry benefit which may change in the future.

The decision of how far out to hedge will depend on cash outlay constraints, credit utilization, and shape of the forward curve.

If you’d like to discuss your specific situation or information regarding our tailored FX risk management services, reach out to your FX contact or email GroupFXSalesGFB@firstcitizens.com.