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Investment hedging: FX hedging for global fund investments

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Value proposition | Short-dated FX forwards can be used to help eliminate the FX rate uncertainty that arises between the time a global fund investment is contracted and the time the deal is funded.

Situation

US-based Global Fund (“Fund”), which has raised US dollar (USD) capital, submits a bid for an overseas asset priced in euros (EUR). The bid is accepted on October 1 and will be funded three to four weeks later. Simultaneously with the acceptance of the bid, the Fund may look to make a capital call for the USDs needed or instead opt to draw down from the capital call borrowing facility closer to the funding date. Either way, the amount of USDs needed will change between the bid acceptance date and the date the transaction is funded.

If the EUR appreciates, more USDs will be needed as the price is fixed in EUR. As a result, the Fund would need to call for more USD capital to close the transaction. This is an undesirable situation, as investors will have paid more for the asset than originally negotiated, eating into internal rate of return (IRR) and other investment performance metrics.

On the other hand, if the EUR depreciates and a capital was made on the bid acceptance date, capital will need to be returned, as fewer USDs will be needed for the acquisition. Economics aside, having to give capital back presents and administrative and operational burden which many times renders the windfall more trouble than it’s worth.

Potential size of FX rate movement

According to the long-term average price for an at-the-money option in the EUR/USD exchange rate1, we can assign a 1 in 10 chance that the EUR may move more than 5.2 percent in either direction over a 4-week period2.

Solution

An FX forward is a contractual obligation to exchange one currency for another at a pre-determined fixed rate and specific date in the future.

Purchase contract

The Fund agrees to pay €50.0M to acquire an asset from a European seller, which translates to $57.5M according to the spot rate on October 1, the day the bid is accepted. Funds will be remitted in 3 to 4 weeks.

Trade details
  • EUR/USD spot reference: 1.1500
  • Direction: Buy EUR / Sell USD
  • Notional: €50.0M
  • Contract rate: 1.1530
  • USD equivalent: $57.65M
  • Tenor: 4 weeks
Notes: Conservative (i.e. longer) tenors are advisable as it better to draw down the trade early than having to roll it forward, as the latter involves a cash event. Contract rate for buying EUR forward is less favorable than the prevailing spot rate, resulting in a $150,000 difference between the USD needed for the forward transaction. The pricing of FX forward contracts is derived from three market factors: 1) spot exchange rates, 2) interbank interest rate differentials, and 3) cross-currency basis swap rates. For EUR/USD forwards, because US interest rates are higher than EU interest rates (net of crosscurrency basis), the hedger receives a less advantageous rate for buying euro forward versus spot.

Scenario analysis

The total USDs needed to close an overseas purchase can change materially over a 4-week period, from bid acceptance to deal funding. According to an objective probabilistic framework, there is a 10 percent chance that on a €50.0M price tag, the price can change by more than $3.0M in either direction. However, regardless of where the EUR/USD exchange rate should be trading on expiry date, according to the terms of the forward contract, the Fund will be selling $57.65M in exchange for €50.0M to make the investment.

 

Additional considerations

  • In the event the deal were to close earlier than expected, forwards may be drawn down or unwound early without penalty. The Fund would not be exposed to spot risk, only movements in the forward curve. However, the economic impact of forward curve volatility is generally minimal over short horizons.
  • A delay in the expected deal close date can be handled by rolling the forward for an additional week, month, etc. as required. A “roll” is a standard FX contract, which does require cash settlement.
  • An FX credit line or collateral posting is required to execute forwards. These are small for short-dated tenors.

If you’d like to discuss your specific risk profile, contact Bobby Donnelly at bdonnelly@svb.com, West Coast/Central, or Ben Johnston at bjohnston@svb.com, East Coast. You can also contact the author, Ivan Oscar Asensio, Head of FX Risk Advisory, at iasensio@svb.com.

Read our other FX Risk Advisory papers.

1 Assumes an average implied volatility, IV, for the EUR/USD exchange rate of 11.5%.
2 Projected loss determined by IVT x SQRT(T) x Z(.90), IV is implied volatility, T is years, and Z is from standard normal such that P(Z<z).

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This content is intended for US audiences only.

This material, including without limitation the statistical information herein, is provided for informational purposes only. The material is based in part upon information from third-party sources that we believe to be reliable, but which has not been independently verified by us and, as such, we do not represent that the information is accurate or complete. The information should not be viewed as tax, investment, legal or other advice nor is it to be relied on in making an investment or other decisions. You should obtain relevant and specific professional advice before making any investment decision. Nothing relating to the material should be construed as a solicitation or offer, or recommendation, to acquire or dispose of any investment or to engage in any other transaction.

Foreign exchange transactions can be highly risky, and losses may occur in short periods of time if there is an adverse movement of exchange rates. Exchange rates can be highly volatile and are impacted by numerous economic, political and social factors, as well as supply and demand and governmental intervention, control and adjustments. Investments in financial instruments carry significant risk, including the possible loss of the principal amount invested. Before entering any foreign exchange transaction, you should obtain advice from your own tax, financial, legal and other advisors, and only make investment decisions on the basis of your own objectives, experience and resources.

Opinions expressed are our opinions as of the date of this content only. The material is based upon information which we consider reliable, but we do not represent that it is accurate or complete, and it should not be relied upon as such.

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About the Author

Ivan Oscar Asensio advises global corporations and institutional investment managers on solving problems related to currency risk. He has held similar roles at HSBC, Merrill Lynch & Co., and Bank of America in New York, San Francisco and Los Angeles.

His approach when engaging clients involves the use of quantitative techniques for purposes of risk discovery, risk quantification, and ultimately the development of tailored strategies that are consistent with the institution’s stage in the life cycle, performance objectives, desired accounting presentation, and risk tolerance.

Dr. Asensio received his Ph.D. in economics from the University of California, Santa Cruz. He also holds an M.S. degree in statistics from UCLA, and dual-undergraduate degrees in finance and mathematics from USC.
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