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The ins and outs of an FX hedging decision

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Making a foreign exchange (FX) hedging decision is never a straightforward process and to compound the issue, the FX market has a tendency to swiftly punish those that take their eye off the ball.

That being said, with the right structure and processes in place, the decision-making process becomes clearer and more manageable. In the current economic and political environment, currency pairs that have been relatively sedate have become far more volatile, to the point where movement can quickly affect the performance of an asset. 

Since the UK referendum and US election, the focus on FX has intensified and the question of whether or not to engage in FX hedging has become far more prevalent.

With the currency fluctuations associated with Brexit, some property developers have experienced being ‘not fully funded’, and some investors have made significant losses because of the pound weakening. On the flip side, there have also been those who have made significant gains as a result of repatriating funds.

Prior to embarking on the analysis of an FX exposure, it is crucial to understand the metrics that are important to the situation.

This will depend on the strategy that is being pursued. For example, in the case of core and core plus strategies in the real estate sector, the key metrics tend to be the amount of free cash available for paying a dividend and Assets Under Management (AUM).  With an Opportunity or Value Add fund the key metric tends to be Internal Rate of Return (IRR).  For developers, the objective could simply be remaining fully funded.  Once the objective of the strategy is understood, it is possible to embark on an analysis of the situation.

There are three key stages to being able to make a well-informed FX hedging decision.

You need to understand:

  1. Key performance metrics and the assets involved
  2. The impact of exchange rate movements on these key metrics
  3. The costs and benefits of utilising hedging instrument

To provide an illustration, let’s consider these three stages in the context of a real estate fund. 

  1. Key performance metrics and the assets

In order to understand the objective of the hedging programme, it is important to define the key performance metrics for the fund. The next step is to model how the assets contribute to the performance metrics.

  1. Impact of FX movements on key performance metrics

Once the exposure is understood, the second stage of the process is to model the potential impact of FX movements on the performance metrics. There are a number of approaches that can be used to give this analysis a sense of realism. 

The three preferred approaches are:

- Scenario analysis

- Back testing - using historic market data

- Expected future exposure - using market implied volatility

By combining these approaches, it is possible to show the sensitivity of key metrics to FX movements.  This will also show the volatility of the potential returns as a result of changes in the FX rates. 

In a multi currency portfolio, some advisors recommend relying on currency correlations when completing the analysis.  This does give additional information, however from a risk management perspective it needs more careful consideration as invariably, historic correlations breakdown in distressed circumstances, leaving your portfolio exposed at the exact point in time when volatility is often highest!

If the output from stage two shows an acceptable level of volatility in the key metrics, then there is no need to proceed to stage three and it is perfectly acceptable to be unhedged. 

  1. Impact of hedging

This stage involves constructing a hedging strategy and testing its effectiveness in different circumstances.   As this is a risk mitigation exercise, the hedging strategies may consist of options, forwards or combinations of both with an objective to keep it simple.  To illustrate this phase we consider two examples - hedging with a forward and hedging with an option.

Using a forward gives certainty of return however, on the hedged amount there is no upside benefit if the currency moves in the buyer’s favour.  Additionally, there will be a cash event if the trade needs to be settled prior to the hedged cash flow occurring.  There is also the potential for the forward needing to be collateralised.  Both the cash event and the collateralisation require the maintenance of a level of liquidity that would be deemed inefficient for an opportunistic fund.

Buying an option is another approach but this requires a cash payment, typically at the point of purchase.  The buyer does benefit from the upside in the event that the currency moves in their favour however; the premium paid for this benefit is often seen as too high by some investors.

                                      FX_hedging_decision

There are ways of mitigating some of the challenges described above, but there is always a compromise which needs to be considered in the context of the business plan for the investment and the impact on the key metrics.

In times of heightened FX volatility, it is important to be aware of the impact that a change in FX rates can have on project costs or investment returns.  It is also important to recognise that deciding not to hedge may also be a perfectly acceptable strategy providing the decision comes about as a result of a rigorous analytical process.  By applying the methodology described above, it is possible to make a clear, informed hedging decision and continue to monitor your exposure through the life of a portfolio of investments.

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