The Basis is a quarterly presentation series by our Liquid Markets Group’s Multi-Asset Solutions team providing investors with insights into derivative structures and strategies, portfolio construction and other whole-of-portfolio investment topics.
In this edition, we dive deeper into one of the topics in this quarter’s The Basis to explore various approaches to currency hedging based on the underlying asset mix.
Asset mix is an important determinant of the optimal currency hedge structure
Tracking error tolerance, available liquidity and the mix of listed and unlisted assets are all important factors when determining the most appropriate FX forward tenor.
Types of underlying assets:
- Benchmark tracking funds
- Diversified funds with majority of listed assets
- Diversified with concentration of unlisted assets
- Specific unlisted assets
1. Benchmark tracking funds
Minimising tacking error is the primary objective.
- Suitable for funds with immediate access to liquid assets
- Typically seen in passive listed equities mandates where minimising tacking error is the primary concern
Opportunities:
- Ability to closely match benchmark hedging methodology
- Funds available for reinvestment if hedge is profitable
- Counterparty risk limited in duration
Watch for:
- Liquidity window very short, typically 2 days
- Settlement amount difficult to forecast, dependent on market volatility
- Full amount rolled each month, fund liquidity risk highly exposed with respect to potential market dislocation
- Exaggerated price-taker status with little flexibility on market timing
2. Diversified funds with majority of listed assets
Small allocation to unlisted assets, ample contingent capital through liquidating listed assets.
- Hedge profile laddered across a number of months, common laddering approach
- Liquidity concerns generally low, liquid asset pool available for settlements
- Constructed with three settlement dates within six months
Opportunities:
- Material drop in liquidity risk as liquidity requirements are smoothed over a number of settlement days
- Extreme currency shocks are reflected in unrealised P&L, cashflow requirements are staggered
- Counterparty risk limited in duration
Watch for:
- Unrealised P&L may cause drag on overall performance (which can be mitigated through 'equitisation' of unrealised gains/losses)
- Counterparty risk extended as bilateral contracts are held for longer
- Slightly higher tracking error reflecting the differing interest rate differentials for longer tenors
3. Diversified funds with majority of unlisted assets
Large allocation to unlisted assets, substantive risk to asset allocation to fund outflows
- Investment style focusing on long-held assets
- Maturity profile reflecting preference for lower liquidity requirements
- Profile extended beyond 12 months
Opportunities:
- Significant mitigation of liquidity risk where cashflow sensitivity is high
- Liquidity requirements less correlated with market volatility
- Long-duration forward profile can extend beyond the reach of a 'correction cycle', amplifying the defence against liquidity risk
- Positions uncollateralised, no variation margin or UMR impacts
Watch for:
- Price spreads widen beyond 12 months, reflecting capital and regulatory charges for banks
- Heightened counterparty credit risk
- Increased tracking error to benchmark methodology
- Unrealised P&L may cause a material drag on overall fund returns (mitigated by 'equitisation' through derivatives)
4. Specific unlisted assets
Access to capital throughout the life of the asset limited, settlement outflows cause distress
- Hedge profile utilises uncollateralised, ultra-long dated forwards beyond two years
- Use case is global private capital funds where there is limited ability to call additional funds
Opportunities:
- Can be structured with "no/low" liquidity requirements through much of the life of an asset
- Return certainty regarding funding costs and interest rate differentials, which assists with budgeting and cross-border comparison of investments
- Currency hedge can be tagged on an asset-by-asset basis
Watch for:
- Approval required to extend bank's credit terms
- Increased bank capital charges expected to be reflected in pricing
- Counterparty exposures can be significant
Key takeaways
Match the currency hedge profile with available liquidity
- Critical to ensure the “tail does not wag the dog” and the currency hedge can be maintained throughout the cycle
- Removing or reducing the currency hedge due to funding concerns is rarely optimal
- Incorporating a high level of planning, forecasting and stress-testing in the hedge design allows you to “have your cake and eat it too”
Implementation focus is critical
- Irrespective of the hedge profile, monitoring and assessment of potential liquidity risks is always warranted
- As circumstances change, undertake the necessary implementation steps to update the hedge profile
- This can include early rolling of positions (“lock-in” strategies) as well as extending the hedge profile
Return impacts
- Execution costs are expected to be higher under long-hedge examples, however this is offset by the potential for positive carry through upward-sloping FX forward and cross-currency basis curves
Further information
With a 20+ year track record of delivering better investment outcomes for our clients, we partner with our clients to manage more than A$23 billion in cash and fixed income assets, and A$86 billion in derivatives exposures6. Our team has the specialist skills and deep experience to manage the full spectrum of liquid market investment solutions, including cash and fixed income, a broad set of multi-asset derivative solutions and implementation.
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