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Market Update

Foreign exchange hedging – time to reassess?

Date:
September 10, 2020

Summary

Approaching FX hedging can be complex, given the need to consider the interplay between global markets and the challenges of assessing both costs and benefits. This piece will address some misconceptions about the costs of FX hedging and provide insight for a reassessment of your FX hedging stance.

As the world adapts to a post-COVID era, with all the tumult and upheaval it has brought, commercial real estate investors are reviewing their foreign exchange (FX) risk management strategies, given the large swings evident in the currency markets as the crisis has worn on.

The most common instruments used for FX hedging are FX forwards and FX options, each suitable in different scenarios.

FX options are used when looking to purchase insurance against a worst-case scenario. In pursuing this option, a premium is paid upfront, providing protection at a given strike rate where, the closer the strike rate is to the current spot or forward rate, the more expensive the protection will be. Typically, options are purchased at 5-10 percent “out of the money” to provide protection should the FX rate move negatively. The benefits of options are that they provide a right, but not an obligation, to fulfil the contract. They also allow for participation in beneficial moves in the FX rate, should they occur. However, they are perceived to be more expensive, due to the payment of a premium. But the cost of a hedge should be considered holistically – both the upfront cost and the outcome achieved.

On the other hand, FX forwards are the more commonly used of the two major instruments, allowing you to secure your future exchange rate from day one. The given forward rate for a currency pair, say EUR-GBP, is driven by the interest rate differential between the two currencies and, as such, is a known cost on the inception of the contract. Given that current EUR rates are approximately 0.6% below GBP rates, if you were to hedge EUR back to GBP using forwards, you would lock in a gain of roughly 0.6% per annum. This interplay between interest rate and FX is to eliminate the potential for arbitrage opportunities in the market.

Forwards, unlike options, do not require any upfront payment of premium, and the counterparty charges (either by a bank or a broker) are included into the forward rate quoted to you. This means that if you are looking to hedge from a higher yielding currency back to a lower yielding currency, you can still have a positive return on equity, even after bank charges. Taking our earlier example, your annual benefit may be reduced from 0.6% to 0.4%, which makes forwards an appealing option from a liquidity and interest rate risk standpoint in certain cases. However, FX forwards do have their downsides. If you enter into a contract, you are taking on an obligation to pay a given amount at a given date and, while these can be adjusted with additional forward contracts, there may be significant cash events which you will need to carefully manage. Furthermore, if you take out a forward and rates move sharply, your counterparty may ask you to collateralise your position (post cash) given that the forward contract may become a significant liability generating further potential cash events.

Given the recent conversion of interest rates toward zero percent around the world in response to the crisis, the cost of hedging higher yielding currencies such as GBP and USD back into EUR with forwards has become significantly cheaper over the last few months. Whereas in January it would have cost around 2.5% annually to hedge USD back to EUR, that cost is now 0.8% making investment in the U.S. and UK potentially a more attractive prospect as interest rate differentials narrow.

If this is something you would like to discuss further, or have any additional questions regarding your FX policy, please feel free to reach out and we would be happy to discuss these with you.

About the author


Disclaimers

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.

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