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FX Hedging for Alternative Assets

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 This paper aims to explain the inherent foreign exchange risks which investors with overseas assets are exposed to, and explores ways in which they can be managed.

It discusses the difference between managing the impact that exchange rates have on the repatriation of operating income versus the long-term value of the asset and why forward contracts may not be the best tool to manage longer-term risk. 

Finally, it considers cross-currency swaps as a means to hedge both FX and interest rate simultaneously, thus ensuring that on disposal, the overseas asset does not suffer from a depreciation in value because of exchange rate movements.

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  Foreign Exchange (FX) exposure

 As ‘alternative’ asset sectors have moved towards maturity in the UK, investors are increasingly looking abroad to maintain the yields that first attracted them to the sector.  Consequently, these investments are in currencies other than the one in which the investors report. As a result, they encounter FX risk when converting asset generated income back into the reporting currency.

By examining the FX exposure from the outset and devising a comprehensive financial risk management strategy, investors can be assured that KPIs will not be negatively impacted by fluctuations in exchange rates.

Mitigating FX risk

In recent years, we have seen increasing numbers of clients place more emphasis on the potential risks to their KPIs from adverse FX movement.  This is especially true given the volatility in exchange rates post-Brexit vote. 

Returns exposed to currency movements can be broken down into:

  1. Operating income: Repatriated more frequently, typically on a quarterly or annual basis and can be unpredictable if simply converted at the spot rate at the time.
  2. Underlying asset value: The profit or loss which will be crystalised when the asset is sold and the proceeds repatriated to the home currency.

There are a number of derivatives available to help manage these two risks. 

The technique most commonly employed is a simple forward contract (the sale of foreign currency for the reporting currency) but alternatives such as currency options and cross-currency swaps should also be considered.  

The most appropriate strategy will depend on a number of factors, such as hedging income versus asset value, the need to hedge interest rate as well as exchange rate exposure, credit and liquidity constraints and the overarching hedging objectives. The most widely used derivative options and their advantages/disadvantages are set out in Table 1. 

When the asset is financed using debt, borrowing in local currency and servicing with operating income denominated in the same currency can mitigate a significant amount risk.  However, exposure may still arise where assets are not being financed, and profit repatriation still needs to be hedged.  

Table 1: Common derivative options

 

Forward Contract

Currency Option

Cross-Currency Swap

Advantages

  • Provides certainty of exchange rate
  • No cash premium is payable
  • Simple and widely available
  • Requires a smaller credit line than cross-currency swaps
  • Provides certainty of exchange rate
  • Ability to benefit from favourable rate movements
  • No credit line is required
  • No obligation to exchange e.g. if disposal strategy changes
  • No early termination costs apply

 

  • Provides certainty of interest rate and exchange rate
  • No cash premium is payable

 

Disadvantages

  • Generally used for shorter term hedging
  • Can result in large cash outflows at roll over points
  • No ability to benefit from favourable rate movements
  • Early termination can result in significant break costs

 

  • Upfront cash premium is payable

 

  • Credit intensive
  • No ability to benefit from favourable rate movements
  • Early terminations can result in significant break costs

 

Hedging Operating Income

Post-Brexit sterling weakness has had a positive effect on UK operators repatriating net EUR profit from their overseas operations.  As the value of the EUR has risen relative to GBP, converting EUR income back to GBP has achieved a high yield return.  However, with GBP interest rates widely expected to continue their upward trajectory over the next 12-18 months, this trend could be reversed, although the uncertain nature of Brexit negotiations may overshadow the usual currency gains associated with rising interest rates.  

Given the uncertain future of the GBP/EUR exchange rate, many operators are choosing to lock in some, if not all of their currency receipts at historically attractive levels to remove the volatile swings associated with leaving foreign income unhedged.

Forward Contracts

The simplest approach to hedging income is through the use of forward contracts.  Under a forward contract, the operator agrees to sell an agreed amount of EUR at a pre-determined exchange rate on a specified future date.   These are typically used for shorter term hedging, where the amount of currency to be exchanged and the timing to do so, can be predicted with some certainty (e.g. rental income).

Unlike interest rate hedging which is derived from underlying market interest rates, FX hedging focuses on two closely related rates: spot rates and forward rates.  

Spot rates are constantly updating – reflecting the market’s mid-price for a currency at that moment.  Forward points are the time value adjustment made to the spot rate to reflect a future date.  To arrive at a forward rate, the current spot rate is adjusted by the forward points to reflect the difference between interest rates in the home countries of the currencies involved.   

Example: 

A UK based operator receives EUR 500,000 net rental income each quarter from his European based asset, which he wants to exchange for GBP.

The GBP/EUR spot rate is currently 1.1275 meaning EUR 500,000 is equivalent to GBP 443,456. If GBP 443,456 was invested for six months at a UK interest rate of 0.60% the investment would be worth GBP 446,117

If EUR 500,000 was invested for six month at a EUR interest rate of 0.00% the investment would still be worth EUR 500,000.

EUR 500,000 divided by GBP 446,116 = 1.1208 (the six month forward exchange rate). Hence the forward rate adjustment for six months is -0.0067

Put simply, if the interest rate in the country of the base currency (in this example GBP), is higher than the interest rate in the country for which currency is being bought, (the counter currency, in this example EUR), the interest rate differential and forward adjustment will be negative.  This is a benefit when selling the counter currency at a future date, acting as compensation for sitting in the lower yielding currency for six months.

Therefore, GBP reporting vehicles investing in a EUR asset can take advantage of current EUR interest rates being lower than GBP rates in the sense that, at any point on the current forward curve (see Table 2), the EUR trades at a premium to GBP.  This, of course, can change, as interest rates in the relative countries fluctuate.

Table 2: The GBP/EUR forward curve

 Spot

 1m

 3m

 6m

 9m

 12m

 24m

 36m

 1.1275

 1.1265

 1.1245

 1.1208

 1.1176

 1.1136

 1.0984

 1.0854

 
Unless there is no interest rate differential at all between two currencies, there will always be some shape to the forward curve. Currencies with lower interest rates trade at a premium in the forward market to those with lower interest rates, and vice versa.
 
Currency Options
Some investors prefer to hedge FX risk with FX options. These give the holder the right – but not the obligation – to exchange one currency for another at a pre-agreed rate (strike rate), on a pre-agreed date.
 
Example: 
 
UK based operator (receiving EUR 500,000 net rental income each quarter as per the forward example above) would like to protect the risk that his EUR receipts fall in value versus GBP.  However, he prefers not to lock into the six month forward rate of 1.1208 in case the exchange rate improves in his favour.

 The operator can buy asix month currency option with a strike rate of 1.1200.  This means if GBP/EUR is above 1.1200 in six months’ time, he can sell his EUR at 1.1200. 
However, if GBP/EUR has fallen to say 1.1000, he does not have to exercise his currency option and may simply sell his EUR at the preferable 1.1000 spot rate.

For the flexibility of protecting a worst case rate, whilst retaining the ability to benefit from favourable movements, he will pay a premium of circa EUR 15,000 (per EUR 500,000 protected).
 
As well as allowing the operator to benefit from favourable movements in exchange rates, currency options also offer flexibility where expected receipts are uncertain.  Should the hedge no longer be required, they can be terminated or simply allowed to lapse without associated termination cost
 
Hedging Asset Value 
Managing the FX risk associated with the exit strategy of an overseas asset can be significantly more complex than managing the day to day hedging of operating income.  The lack of certainty surrounding timing and notional means simple forward contracts are not necessarily the most effective hedging tool.
 
Cross Currency Swaps 
Where debt has been raised in the reporting currency in order to fund the overseas asset, (for example by drawing on an RCF), the investor could redenominate this debt by entering into a cross currency swap.  This is an agreement between parties to exchange a loan’s principle and interest payments in one currency, for an equally valued loan and interest payments in a different currency.  This has the advantage of hedging both the associated interest rate on the borrowing, as well as the exchange rate risk involved in investing abroad.

Here the investor would notionally exchange GBP for EUR at the current spot rate and commit to exchange EUR back to GBP at the end of the investment period in, say, five years’ time at the same exchange rate.  In the meantime, the investor would pay a fixed Euribor rate (eliminating interest rate risk) and receive the equivalent three month floating GBP interest.
 
Example: 
A GBP based operator borrows GBP 10,000,000 to invest in EUR denominated assets and converts it into EUR at a spot rate of 1.1275.  It simultaneously agrees to exchange the EUR back into GBP in five years’ time at the same spot rate, thus eliminating the FX risk.

The operator wants to service its interest payments from the EUR income received from its asset, therefore under the cross currency swap it agrees to pay a fixed Euribor rate of 0.20% and receive a floating rate of GBP 3 month LIBOR, thus also eliminating its interest rate risk.
 
Whilst cross-currency swaps are very effective at hedging both interest rate and FX risk, given their long-term nature, they are typically very credit consumptive.  Where existing debt is in place in respect of the underlying asset, it’s likely that the available additional credit for FX hedging may be limited, in which case rolling forwards may be the only feasible strategy available. 

However, if a cross currency swap can be put into place, the hedge will be better aligned to the investment hold period and avoid rollover cash events.
  
Forward contracts – Rollover Risk
Whilst short-term forward contracts are sometimes used to hedge the long term risk associated with protecting asset values, a disadvantage is that at maturity, they may need to be extended, or ‘rolled over’, at which point the investor may experience a negative cash event which impacts liquidity.  Whilst forward contracts can be undertaken for up to five years in some currency pairs, credit constraints mean they are typically booked for up to 12 months in advance. 
 
Example:
A GBP denominated operator buys EUR 50,000,000 at spot to purchase a EUR denominated investment which he intends holding for a five year period.  He simultaneously pre-sells the EUR the maximum 12 months forward to convert back to GBP as a hedge. 
 
In 12 months’ time, the operator needs to settle its obligation under the maturing forward, but wants to extend or ‘roll over’ its hedge for a further 12 months, as he has not yet sold the asset.
This can be achieved by executing an FX swap whereby the operator buys the EUR it is contractually obliged to sell under the original forward at
spot and simultaneously sells EUR forward for another twelve months. 

However, if the GBP/EUR exchange rate on the old, maturing forward trade was, for example, 1.11 and the new spot rate at the time of rollover was 1.04, the investor would have made a loss on the hedge of seven cents or approximately GBP 3,000,000.  This loss (a so-called negative cash event) will be crystalised upon rollover of the forward and will need to be funded - having a significant impact on cash flow.
 
It is important to note that the realisation of a loss on rollover does not have an impact on the overall return of the investment but it does have a short-term cash impact.  In our example, as it rolls over its forward, the investor loses seven cents on the spot leg of the FX swap but gains seven cents on the forward leg, since the 12-month forward rate will also have moved lower in parallel with the spot rate. However, this will be no consolation if the loss on the spot leg cannot be funded until it is offset, in 12 months’ time, by the profit on the new forward.
For this reason, where there is a requirement to protect the value of the asset from exchange rate fluctuations on disposal, a currency option may prove a more viable hedge as once the premium has been paid, there are no further cash flow implications.
 
Breakage costs in the event of early disposal of an operating asset
If an asset is sold early, while an FX forward or cross currency swap is still in place, the investor is protected from a spot perspective. However, the investor will have an interest rate exposure in the event of early termination.  If EUR rates have moved higher relative to GBP rates, this will work to the investor’s advantage, and vice versa. While this interest rate risk is small relative to spot risk, investors should nonetheless familiarise themselves with its mechanics prior to implementing FX hedging.   Note there will be no breakage costs where a currency option is terminated before maturity.
Summary 
 
1. When considering the diversification of an asset portfolio by investing abroad, due consideration must be given to the resulting currency exposure, since adverse movement can render a profitable venture into a loss making scheme.  This should be incorporated into the initial investment decision.
 
2. The appropriate hedging solution will depend on the currency pair involved, the source of funding, method of servicing debt costs and the future disposal strategy.
 
3. Forward contracts and options can both be used to hedge the repatriation of operating income.  Forwards may not be suitable for hedging the underlying asset value due to rollover risk.
4. The pricing, implications and suitability of hedging tools can be complex and independent advice should be sought before implementing a hedging strategy.  An independent advisor can recommend a hedging strategy which will align with your business requirements and ensure bank pricing is fair and consistent with market practice.  If you would like to discuss the options available to you, please get in touch with our team who will be delighted to provide an overview of how we can help.   

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