The blog discusses the approach funds with assets denominated in currencies different from their base currency take to hedge Foreign Exchange (FX) risk related to fund exits. It highlights why EUR private funds with USD assets are moving from rolling short-dated forwards to longer-dated FX hedging.

Bottom line

• Private funds with assets denominated in a currency other than their base currency often choose to hedge the foreign exchange (FX) risk of a future asset exit.
• The difference in interest rates between the relevant currencies (interest rate differential) is the main driver, thus dragging on the costs of hedging a future exit.
• The most frequently deployed FX hedging strategy for fund exits is to roll short-dated (1 to 3 months) forwards up until the exit date.
• A rolling, short-dated strategy removes the spot FX risk but keeps the fund exposed to changes in the interest rate differential.
• Managers expecting the ECB to drop rates quicker than the FED are locking in current hedging costs by moving away from hedging by rolling short-dated forward in favour of longer-dated FX exit hedging strategies.

Exit hedging

A private fund invested in foreign-denominated assets is expected to be exposed to Foreign exchange (FX) fluctuation during its 3 to 5-year holding period. FX fluctuations over that time horizon can be significant, and may adversely impact the Fund Internal Rate of Return (IRR). A manager’s choice to hedge their FX exposure of a future exit will consider the expected FX volatility, cost of hedging, its investor mandate, the manager’s appetite for taking risk, and the availability and access to of FX hedging instruments.

Rolling short-dated forwards

Managers often use FX forward contracts to hedge against currency movements. The most frequently deployed FX hedging strategy for fund exits is to roll short-dated (1 to 3 months) forwards up until the exit date. A rolling short-dated hedging strategy removes the spot FX risk but keeps the fund exposed to changes in the difference in interest rates between the hedged currencies (interest rate differential). The interest rate differential is the main driver of hedging costs, as it drives the forward exchange rate (or forward price).

Volatility in forward pricing tends to be less material over short horizons, especially in the absence of structural changes as compared to volatility in FX spot levels. This means that short-dated FX hedging strategies, which hedge the spot FX risk, tend to work best in the absence of structural economic changes and a strong view of rate movements.

Longer-dated forwards

An alternative to rolling short dated forwards is to hedge with a longer dated forward with a tenor that sufficiently covers the expected holding period of the asset. In the event the exit was to be done earlier than expected, forwards may be unwound early, maintaining the position as hedged. Opting for a longer-dated forward strategy requires greater credit to enter into but does limit the exposure to changes in the interest rate differential.

Central bank divergence and exit hedging

Driven by the divergence in economic performance between Europe and the US the interest rate differential in EUR/USD has seen the sharpest widening since the pandemic. An increasing number of Fund managers is projecting different paths of interest rates at each side of the Atlantic. As a response, managers with EUR funds with USD denominated assets are increasingly locking in current forward curves by moving away from rolling short-dated forwards in favour of longer-dated FX exit hedging strategies.

How Ebury Institutional Solutions can help your fund

• Access wide-ranging FX hedging instruments to support fund managers.
• Support in setting up a FX hedging strategy and choosing suitable FX instruments.
• Offer long tenor forwards enabling hedging up to the expected exit date
• Limit cash drag impact by requiring no or low collateral to set up and maintain FX hedges.

Let’s start a conversation

Get in touch with our experts to discuss the needs of your fund and how Ebury can help you. You can also visit our page to learn more about our solution.

Disclaimer

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