- FX rate uncertainty arises from the time an international portfolio company is sold and the funds are repatriated
- The potential impact on Internal Rate of return (IRR) can be significant
- Short-dated forwards can be used to help mitigate the impact of currency fluctuations during this period
Value proposition | Short-dated FX forwards can be used to help mitigate the FX rate uncertainty that arises between the time a portfolio company is sold and the funds are repatriated back.
A USD-based fund has a European investment that has recently matured. The repatriation process can take up to a month before all docs are finalized. Although the final EUR amount figure is known, the timing of the repatriation is unknown. The timing on the transfer of funds back to the US is estimated to be 3-6 weeks.
Should EUR appreciate in the interim, the total return (investment yield + FX yield) will increase. However, should EUR depreciate before the final conversion, the total return will decrease resulting in a lower overall final IRR.
To eliminate potential losses due to currency fluctuation, FX derivatives are often used to mitigate this risk so that firms can focus solely on the investment-generated returns.
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 percent in either direction over a 4-week period2.
An FX forward is a contractual obligation to exchange one currency for another at a pre-determined fixed rate and a specific date in the future.
The fund sells the portfolio company for €50.0M to exit their investment. This translates to $57.5M according to the spot rate on the day the portfolio company was sold. Funds will be repatriated in 3 to 4 weeks.
EUR/USD spot reference: 1.1500
Direction: Sell EUR / Buy USD
Contract rate: 1.1510
USD Equivalent: $57.65M
Tenor: 4 weeks
Notes: Conservative (longer) tenors are advisable as it is better to draw down the trade early than having to roll it forward, as the latter involves a cash event. The contract rate for selling EUR forward is more favorable than the prevailing spot rate, resulting in a $150,000 benefit when the USD is received. 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 cross currency basis), the hedger receives a slightly more advantageous rate for selling euro forward versus spot.
The total USDs that will ultimately be repatriated can change materially over a 4-week period.
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 €50.0M in exchange for $57.65M for the exit.
In the event the deal was 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 horizons3.
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 transaction which requires cash settlement.
An FX credit line or collateral posting is required to execute forwards. These are small for short-dated tenors.
You can also contact the author, Ivan Oscar Asensio, Head of FX Risk Advisory, at email@example.com.