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Many debt funds make loans in currencies other than the one in which they report and as a result, they encounter foreign exchange (FX) risk. A depreciation of the currency in which the asset is held versus the reporting currency leads to a diminution in the asset’s value (and related coupons) as measured in the reporting currency. For example, a EUR denominated fund that, pre-Brexit referendum, made a £10 million loan at 1.3000 (EUR13 million) would now have an asset of only EUR11.75 million (£10 million at 1.1750), following sterling’s depreciation.
Most debt funds seek to mitigate this risk through FX hedging. Unfortunately, there is always a cost to hedging either in terms of credit consumption or cash. Given debt funds’ lower IRR than equity funds, the relative cost of hedging tends to be higher for a debt fund. Nonetheless, in the vast majority of cases, the desire to ‘lock down’ as much risk as possible means debt funds are more likely to hedge than equity funds.
In this short whitepaper: FX hedging for private debt funds, originally published in Private Equity International's book Private Debt Investor - The Global Guide to Private Debt , James Stretton discusses the source of FX exposure for debt funds, the methods of mitigating such exposure, and some of the challenges and choices around that process of mitigation.
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