Introduction
Currency sleeves are created to facilitate cross-border capital-raising activities. This provides the fund manager with access to offshore LPs with currency exposure restrictions or preferences.
Hedged currency sleeves offer investors the benefit of being able to deploy into the respective currency share class while also receiving distributions in the same currency as the capital was deployed. This is most frequently seen in strategies where FX volatility can overwhelm a strategy's characteristics, as seen in private credit, real estate, and infrastructure.
This paper provides an overview of:
- Key considerations for fund managers when setting up a currency hedging program for their sleeves
- Scenario analysis of two hedging strategies
- Implementing a hedging strategy utilising FX Forwards, a main hedging product used by managers
Common approaches to FX forward hedging
Spot and forward rate
The FX spot rate represents the current market price for an immediate exchange of currencies. On the other hand, the forward rate is the agreedupon price for an exchange that is to take place at a predetermined future date. The FX forward rate accounts for the interest rate differential between the two currencies (forward points) and hence differs from the spot rate.
Forward points
The difference between the FX spot and forward rates is driven by the interest rate differential between the two currencies. Here is an example below:
- 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 spot 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
Upon reaching the maturity of a FX Forward contract, instead of terminating, the contract is extended or "rolled over" at the new forward rate. The difference between the new forward rate and the previous forward rate will generate a gain for one party and a loss for the other party.
This process is referred to as "rolling" and can be continued indefinitely. Gains or losses on each forward are accumulated. 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.
Cost of hedging
The cost of hedging is driven by:
- Forward points
- Cash drag/liquidity needs of hedging
- Margin of financial institutions for offering the FX forwards
Key considerations in setting up a sleeve currency hedging programme
Here, we will discuss two key design choices fund managers need to make in setting up an FX hedging program for a currency sleeve. 1) Setting the hedging frequency or tenor of the FX hedges used 2) Setting the most appropriate hedge ratio for the hedging program.
1. 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 allows for easily increasing and decreasing the hedged principle as at each role the hedged principle can be increased or decreased. Rolling hedges therefore are well suited to situations where a principle is amortised.
Liquidity impact / Cash drag
Whether the liquidity needs of shorter dated hedging are more or less versus longer dated hedging depends on the conditions offered by the financial institution. Typically the margin requirements demanded by the financial institution 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 (example: EUR investor in USD where 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.
2. Hedge ratio
Managers usually leave some operational leeway in their commitment to hedge the currency sleeve. In some cases, an explicit decision is made to hedge less than the principle (hedge ratio < 1). Managers make a tradeoff between the cost of hedging and the LP's preferences and expectations regarding the degree to which they should be hedged against currency risk.
Simulation hedging strategy
Two hedging strategies are explored to hedge the capital contributions in a EUR sleeve of a USD fund. A 1-year rolling hedging strategy and a hedge up until the expected capital distribution. The hedges are simulated against a scenario in which the EUR appreciates against the USD.
The currency protection of the principle is the same for both strategies, but the liquidity impact of the two strategies differs. In the example provided here, the EUR/USD forward points are static throughout the hedge period. In reality, the forward points will fluctuate, but the volatility tends to be significantly less 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.
Returns generated in the fund are not hedged but returned against the spot FX rate to the LP. The total hedged EUR distribution to the investor is the sum of the principle notional converted to EUR, the result of the FX hedge, and the EUR value of the fund returns.
The appendix shows the same two hedging strategies simulated against an USD appreciation scenario. The simulation shows both strategies resulting with the same EUR distribution of the principle.
In a nutshell
Different hedging strategies can be deployed to hedge against FX volatility with similar degrees of protection. These strategies can have different impacts on liquidity and resulting cash drag and offer different degrees of flexibility in changing the hedged principle over time. As funds have different access to FX hedging facilities with varying conditions, each manager must make unique trade-offs between liquidity requirements, hedge costs, LP preferences, FX trade line availability, and views on future interest rate differentials.
The key design choices fund managers need to make in setting up an FX hedging program for a currency sleeve are:
- Setting the hedging frequency or tenor of the FX hedges used
- Setting the most appropriate hedge ratio for the hedging program
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