Currency sleeve hedging: A guide for fund managers
Understand forward pricing, margin and cost drivers, then choose the right tenor and hedge ratio for your fund.
Understand forward pricing, margin and cost drivers, then choose the right tenor and hedge ratio for your fund.
More about this guide
Currency sleeves enable fund managers to raise capital across borders, opening access to offshore LPs with currency exposure restrictions or preferences. Hedged currency sleeves let investors deploy into the respective currency share class while receiving distributions in the same currency as the capital was deployed. This is most common in strategies where FX volatility can overwhelm a strategy’s characteristics, such as private credit, real estate, and infrastructure.
In this guide, you'll learn:
Types of hedging instruments suitable for currency sleeve hedging
Before setting up a hedging facility, it helps to understand how FX forward contracts work. This section covers the building blocks fund managers rely on: how spot and forward rates differ, what drives that difference, how rolling hedges work in practice, and the margin and cost implications to weigh up along the way.
Spot rate
The FX spot rate represents the current market price for an immediate exchange of currencies.
Forward rate
Unlike spot rate, the forward rate is the agreed-upon price for an exchange that is to take place at a predetermined future date.
Forward points
The difference between the FX spot and forward rate is driven by the interest rate differential between the two currencies.
For example:
- USD/EUR spot rate is at 0.85
- 1 year US interest rate 4%
- 1 year EU interest rate 2%
- Forward points are 200bps
- 1 year USD/EUR forward rate: 0.83 (=0.85-200/10,000)
With US interest rates higher than those in the EU, the forward rate for selling USD to buy EUR is worse than the spot rate. EUR investors who invest in USD and hedge future returns back into EUR will hurt their IRR, driven by the forward points. The asset manager balances the benefits of FX volatility hedging against its negative impact on IRR.
Rolling hedging
When a forward contract matures, instead of terminating, the contract is extended, or “rolled over,” at a new forward rate. The difference between the new forward rate and the previous forward rate generates a gain for one party and a loss for the other.
This process is called “rolling” and can continue indefinitely. The fund accumulates gains or losses on each forward contract. When a distribution is due back to the investors, the fund allows the existing forward to terminate without rolling it over.
Margin call
Depending on the credit conditions of the trading line offered by the financial counterparty, the manager might be required to post the margin to be allowed to book a forward contract (called an Initial Margin). In addition, the manager might be called to post an additional margin (Variation Margin) if the market value (mark-to-market) of the FX forward moves significantly in favour of the financial institution. Typically, the margin requirements increase with the tenor of the forward contracts. This is one of the reasons managers often opt for hedging with a shorter tenor.
Factors driving cost of currency sleeve hedging facilities
The cost of hedging is driven by:
- Forward points
- Cash drag/liquidity needs of hedging
- Margin of financial institutions for offering the FX forwards
Together, these mechanics – spot versus forward pricing, the roll of a hedge, margin requirements and the resulting costs shape the trade-offs fund managers face when hedging a currency sleeve. Understanding how they interact is the foundation for the two key decisions covered next: setting the right hedge tenor and hedge ratio for the fund.
Steps to establish a currency hedging program for a currency sleeve
Here, we will discuss two key design choices fund managers need to make in setting up an FX hedging program for a currency sleeve.
- Setting the hedging frequency or tenor of the FX hedges used
- Setting the most appropriate hedge ratio for the hedging program.
Hedge frequency/FX forward tenor
Managers take into account multiple dimensions in order to choose the tenor of FX forwards best suited to their fund:
Need for flexibility
A rolling hedging strategy with short-tenor FX hedges lets you easily increase or decrease the hedged principal at each roll. Rolling hedges are therefore well suited to situations where a principal is amortised.
Liquidity impact / Cash drag
Whether the liquidity needs of shorter-dated hedging are more or less than those of longer-dated hedging depends on the conditions offered by the financial institution. Typically, the financial institution's margin requirements increase with the tenor of the forward contracts, making the cash drag from a shorter-dated FX hedging strategy potentially better in these cases.
View on interest rates differential
If the manager has a view that the interest rate differential will move in favour of the investor in the future (e.g., a EUR investor in USD where the manager expects the interest rate differential between EUR and USD to decrease).
Cost efficiency
Longer-term hedges may require a larger premium due to the increased uncertainty over a longer period.
Hedge ratio
Managers usually leave some operational leeway in their commitment to hedge the currency sleeve. In some cases, managers explicitly decide to hedge less than the principal (hedge ratio < 1). Managers trade off the cost of hedging against the LP’s preferences and expectations about how much currency risk should be hedged.
Simulation hedging strategy
To see these decisions in action, we've modelled two hedging strategies for the capital contributions in a EUR sleeve of a USD fund: a 1-year rolling hedge, and a hedge held until the expected capital distribution. Both are tested against a scenario in which the EUR appreciates against the USD.
The currency protection of the principal is the same for both strategies, but the liquidity impact differs. In the example provided here, the EUR/USD forward points are static throughout the hedge period. In reality, forward points fluctuate, but their volatility is typically much lower than that of the spot FX rate. Managers with a strong view of the interest rate differential tend to reflect that view during the hedging period.
The fund's returns are not hedged but are returned to the LP against the spot FX rate. The total hedged EUR distribution to the investor is the sum of the principal notional converted to EUR, the result of the FX hedge, and the EUR value of the fund returns.
Simulation hedging strategy USD appreciation
This shows the same two hedging strategies simulated against an USD appreciation scenario. The simulation shows both strategies resulting in the same EUR distribution of the principal.
Getting the right balance for your fund
Different hedging strategies can offer similar degrees of protection against FX volatility, but they're far from interchangeable. Each affects liquidity and cash drag differently, and offers different flexibility to adjust the hedged principal over time. Because each fund's access to hedging facilities and the attached conditions vary, there's no one-size-fits-all approach. Each manager needs to weigh up liquidity requirements, hedge costs, LP preferences, trade line availability, and their own view on future interest rate differentials.
In practice, this comes down to two key design choices: hedge frequency or tenor, how often FX hedges are set and rolled, and how much of the principal to hedge (hedge ratio). Getting these right is less about finding a universal answer and more about finding the approach that best fits your fund's specific circumstances.
Frequently asked questions on key risk management considerations when implementing a currency overlay strategy
What is a currency sleeve?
A currency sleeve is a share class within a fund denominated in a currency other than the fund's base currency, allowing offshore LPs to invest and receive distributions in their own currency.
How do forward rates differ from spot rates?
The difference, known as forward points, is driven by the interest rate differential between the two currencies involved. It's not a forecast of where the spot rate will go; it's a reflection of the relative cost of holding each currency over time.
What are best practices to manage currency sleeve hedging?
In practice, a hedging currency sleeve comes down to three key design choices: hedge frequency or tenor, how often FX hedges are set and rolled, and how much of the principal to hedge (hedge ratio). Getting these right is less about finding a universal answer and more about finding the approach that best fits your fund's specific circumstances.
Should a fund hedge 100% of its currency sleeve?
Not necessarily. Managers often set a hedge ratio below 1, balancing the cost of hedging against LP preferences and their appetite for currency risk.
Why would a manager choose a shorter hedge tenor?
Margin requirements tend to increase with the tenor of a forward contract, so shorter-dated hedges can reduce cash drag. However, the right choice also depends on the manager's view on interest rate differentials and cost efficiency.
Glossary of terms
The information provided herein is general in nature and should not be construed as financial or investment advice. The information provided here is not legally binding. The information, data or views expressed here is for the exclusive use of the recipient and is subject to changes without any notice. You may ask the support team or your dedicated relationship manager to provide additional information regarding Ebury products.
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Ebury is a global fintech powering international growth for ambitious businesses in a frictionless economy. With majority backing from Santander, we offer an integrated, cross-border platform for payments and currency risk management, together with local market expertise.
Ebury is a global fintech powering international growth for ambitious businesses in a frictionless economy. With majority backing from Santander, we offer an integrated, cross-border platform for payments and currency risk management, together with local market expertise.
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