This is an epochal moment for our generation. It is sobering how quickly and harshly our world has changed. The COVID-19 crisis will cast a long shadow and we can expect lasting changes to how individuals work and live, how companies think about supply chains, risk management, and business continuity, and how governments respond to unknowns and coordinate policy responses within and across countries.
Many of Chatham’s clients are global private equity funds with cross border investments, and we spend a lot of time on currency hedging—having strategy conversations with managers and partners, formulating risk management policies and processes, providing industry color and answering investor questions, structuring and executing currency hedges, walking clients away from sub-optimal decisions, etc. Given the multiple standard deviation movements in currency rates since the COVID-19 pandemic unfolded, unsurprisingly we are fielding numerous calls. Here’s a condensed list of hot topics:
What can I do now?
Market volatilities have increased dramatically in the last two weeks, causing currency options to be painfully expensive. For USD-denominated clients, 3-month costless collars to tide over the immediate term is not providing any real protection, while entering into forwards means locking in the current levels and the FX translation losses, which is patently unattractive. For clients who have hedged their foreign currency exposures, their positions have become significant mark-to-market gains, which makes re-couponing tempting (see below). But closing out these positions to pocket the mark-to-market gains and becoming un-hedged is generally not advisable except under special conditions.
More constructively, certain clients can consider restructuring their hedges so that they would protect a larger percentage of their foreign currency exposures, and enjoy upside from the potential reversal of U.S. dollar strength to U.S. dollar weakness. This can be executed thoughtfully to make use of the mark-to-market gains without overpaying for “vol” in these market conditions.
Non-USD denominated clients (such as funds denominated in British pounds, euros, Australian dollar, etc.) may view the USD strength as an unexpected opportunity to lock in the FX translation gains. We would advise against spur of the moment decisions and remind them to adhere to their risk management policy, and to execute with due attention toward minimizing margin calls. Those who have put in the hard work of formulating a risk management policy at the start, onboarding with the right counterparties, working through derivatives-related regulations in order to access a full suite of products without facing daily margins, implementing robust liquidity management—they may be well-positioned to take advantage of this opportunity.
In addition, this is an appropriate time for clients to step back and review the overall robustness of their risk management. Is the policy overly restrictive such that the manager loses maneuverability in these market conditions? Are any of the Additional Termination Events in the ISDA Schedule in danger of being triggered? Does the fund have adequate Credit Support Annex thresholds to forestall liquidity strains via margin calls? Or should the client proactively open a dialogue with bank counterparties to revisit these critical terms? Does the client have a diversified pool of trading counterparties, or would the client be severely impacted if the counterparty (or counterparties) were to cease trading? Given work-from-home directives, does the fund or its FX advisor have the capacity to promptly and seamlessly execute FX transactions, and maintain its objective of best execution for the sake of its stakeholders?
Could I have done something earlier?
For USD-denominated clients with foreign currency exposures, such as the Australian dollar, Brazilian real, Mexican peso, etc., it is natural for them to ask whether they could have executed new or top-up hedges in January or February. EUR-denominated clients with exposures to the British pound share the same sentiment. While the question is understandable, it is worth reiterating that the market movements have been unprecedented in speed and scale.
It is possible to buy protection in times of heightened risk, but the real question is whether we can do so before the risk materializes and costs spike. It is extremely difficult to call market turns, and to pursue this one must be prepared for many wrong calls and false signals. Also, these preemptive hedges can become expensive cumulatively—imagine buying 3-month currency options every time turbulence is deemed imminent.
For clients whose core competence lies in corporate private equity or real assets, the best approach is to formulate a risk management policy at the start, have the policy endorsed by key stakeholders, and review the hedges regularly to ensure that they stay disciplined.
Should I re-coupon my forwards?
Re-couponing means unwinding of an existing FX forward in order to present-value the mark-to-market gains and simultaneously entering into a replacement forward with the same maturity date and notional (i.e., re-striking the forward rate). The sole or primary motivation is to receive the mark-to-market gains today as a cash payment.
The idea is attractive to USD-denominated clients whose forwards against the risk of U.S. dollar strength have become massive mark-to-market gains. EUR-denominated clients who have hedged against the GBP find themselves in the same boat after the 10% slide in the pound against the EUR since the start of the year. But this benefit must be carefully weighed against the costs, of which there are two in particular to keep in mind. First, the bank counterparty will impose a credit charge on the replacement forward, and the value of the credit charge can seriously dent the perceived benefit of the whole exercise. Second, re-couponing effectively resets the mark-to-market values of the forwards, which in turn increases the odds of posting margin to the bank counterparty. Hence the performance drag from posting margin must be considered, as well.
I have a rolling strategy and my liquidity has been or will be severely strained.
For non-USD denominated clients who have hedged their U.S. dollar exposures, or GBP-denominated funds who have hedged their exposures to EUR, their positions have become significant mark-to-market liabilities. Either they have posted substantial margin to their counterparties or they are looking at the future settlements with dread.
We have long questioned whether rolling 3-month forwards is a suitable strategy for funds with illiquid assets. Back testing shows that a fund needs to set aside an enormous amount of uncalled capital or cash to sustain a rolling program, which is unappealing to managers. One can always halt the hedging program, but the results can be disastrous. For instance, assume a EUR-denominated fund that is hedging against USD exposure. In a period of USD strength, its forwards would become mark-to-market liabilities. Then assume that the fund halts the hedging program in order to stem the bleeding (of liquidity), and thereafter the USD weakens against EUR. The fund would suffer “twin losses”—losses on the forwards, then FX translation losses on NAV.
In the same vein, setting the maturity dates on the same date, say 31 March 2021, would be ill considered because that would concentrate all the hedge settlements on a single date.
The hedging strategy for a fund with illiquid assets is not complicated but is rarely simplistic. It requires a judicious mix of product type, tenor, hedge percentages for the strategy to simultaneously satisfy the investors’ objectives and minimize the costs – including, and especially, the impact of margin calls.
Isn't hedging expensive?
It depends. Currency hedging may in fact be accretive to returns. Since this assertion is often greeted with skepticism, here’s an example: on day 1, a USD-denominated investor converts USD into EUR for an investment in the EU. As of 20 March 2020, the EUR/USD FX spot was 1.0664. Using that, the investor sells USD 106,640,000, buys EUR 100,000,000. At the same time, the investor enters into a sell EUR/buy USD forward as the FX hedge. As of 20 March 2020, the 1-year EUR/USD FX forward rate was 1.0779. So, the investor has a forward contract to sell EUR 100,000,000 and buy USD at 1.0779 one year from today. At the end of one year, assume for simplicity that the investor receives back EUR 100,000,000. Delivering on the forward contract, the investor receives USD 107,790,000. USD 107,790,000 vs. USD 106,640,000 is a gain of 1.1%. A forward contract not only returns more U.S. dollars to the investor but also removes the risk of capital loss due to EUR weakness. Even if the EUR/USD spot were to fall to 1.0000, the investor would still be able to convert EUR 100,000,000 at 1.0779.
If the example were reversed, then hedging U.S. dollar weakness would be dilutive to returns for a EUR-denominated investor at about 1.1% p.a.—down from 2.2% p.a. at the start of the year. However, this cost should not be the only factor in deciding whether to implement a hedging program. The benefit of being protected against unexpected USD weakness should be considered as well.
More broadly, it has become less expensive to hedge U.S. dollar weakness. For a GBP-based investor, the 12-month cost has declined from 1.0% to 0.3%. For an AUD-based investor, from 0.8% to effectively zero. For a JPY-based investor, from 2% to 1.4%.
Every client’s circumstance is sufficiently different and merits a specific, thoughtful response. Please do not hesitate to reach out to your Chatham contact for a further dialogue. Stay well!
Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit chathamfinancial.com/legal/notices/.
Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved. 20-0088
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