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To hedge or not to hedge?

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15 th April 2016
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We are in for a rough ride in international currency markets, but are people prepared for what may lie ahead? This is probably a fair bottom line of the range of topics discussed at JCRA’s FX for Funds breakfast seminar held in London on 14 April 2016. The event was a forum for Property, Debt and Private Equity funds to reflect on currency risks in their investment activities and how to address them.

The session, which featured FX trading veteran and strategist, Simon Derrick (BNY Mellon) and investment professional Tim Haywood (GAM), was led by James Stretton, who is responsible for JCRA’s FX advisory business.

Simon’s tour d’horizon on currency markets covered how the Fed’s policy stance on dollar strength was affecting commodity prices and developing countries (read: China) foreign currency reserves. As the Fed began to taper asset purchases and ultimately hiked rates in December last year, oil prices plunged and emerging market currency reserves melted away. With the very recent dovish remarks coming from Chairman Janet Yellen, however, things have gone into reverse: oil is recovering, China is stabilising and the greenback is weakening.

This has left Japan and Europe in a bind: Yen and Euro strength is the last thing one needs when desperately trying to fight deflation. With their monetary arsenal practically exhausted, the BoJ and ECB are facing a perilous quandary.

Enter Tim Haywood. He picked up on the situation in Europe, focussing on the risk Brexit poses, and touched on how different investor types look at hedging. His general assessment: equity investors don’t hedge, fixed income investors have to hedge and property and private equity investors may hedge currency risk depending on the situation.

Asking the audience who was actively hedging FX risks, several hands went up. However, as Tim and also James later remarked, it is not an easy decision to make, whether to hedge or not to hedge FX risks, if you belong to the latter category, dealing in rather illiquid assets. How can a private equity fund with limited available liquidity and uncertain cash flows set up an FX hedging programme? Would a property investor want to see her IRR dwindle due to hedging costs?

Clearly, there is no simple answer to these questions, but there are solutions and ways of addressing FX risks even for illiquid assets. Irrespective of what type of investor you are, understanding your FX risks is paramount in a world where central banks, political risks and jittery markets can lead to sharp moves in currency markets.

In the near term, and all speakers stressed its importance, Brexit is going to be the biggest source of currency volatility with potentially big ramifications for the already substantially weaker GBP. How, exactly, things are going to play out, is hidden in a cloud of uncertainty.

In the light of the immediate Brexit risk, even those who find it hard to implement an ongoing FX hedging programme, may want to carefully examine what a victorious ‘leave’ campaign would mean for their investment.

If one anticipates transacting significant GBP positions during the second half of the year, now may be a good time to prepare accordingly.

All views expressed in this blog are the author's own and are based on information available at the time of writing.

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