The main objective when it comes to hedging currency risk is to protect against adverse movements in currencies impacting the overall performance of the fund.
As an example, when GBP/USD fell approximately 20% in 2016, a US dollar fund with a 20% exposure to Sterling assets would have had a 4% negative impact on the Net Asset Value (NAV).
When considering currency exposure, the questions a fund must ask are:
- Can I accurately evaluate the FX risk in the fund?
- Should I actively hedge this risk?
- How should I go about hedging – How much? How long? Which instrument?
When making the decision of whether to hedge the currency risk, one needs to weigh up the size of the risk (i.e. how material is it) versus the cost of hedging.
Many would see ‘cost’ as opportunity cost i.e. that you hedge your risk and then the currency moves in your favour, but there is an actual, real cost to hedging – depending on which currencies are being hedged.
There are also transaction costs which need to be taken into account.
There can be a positive contribution to the fund from hedging, due to an interest rate differential between the two currencies.
This can make the decision to hedge easier due to the immediate benefit gained.
This interest rate differential is reflected via forward points.
Due to lower rates currently in the Eurozone, there is an approximate 1.3% benefit for a GBP denominated fund to hedge assets held in Euros.
However, due to the higher interest rates in the US, there is a cost of approximately 1.7% to hedge assets held in the US dollar back to Sterling.
This assessment of the cost is not a static one – and will change over time as markets move.
Therefore any fund deciding to undertake hedging also needs to actively monitor their hedging strategy, and re-calibrate it to ensure it remains optimal and in line with the risk management policy.
Whether or not council pension funds should actively manage this risk also depends on their resources and expertise in this particular area.
It is quite complex, and there are many horror stories of those who have ‘called it wrong’.
To avoid being reactive and driven by market movements, a fund should first detail what its risk management objectives are.
What is it aiming to achieve by undertaking this hedging?
Next, it must undertake an evaluation of the actual exposure – this might require a ‘look through’ analysis to the underlying assets and their FX exposures.
Finally, the fund should be aware that hedging FX risk is not a one-off decision.
It requires monitoring and attribution, and many funds will not have the resources to be able to do this on their own.
Overall, FX exposure is a large risk for many funds and can be material in the context of the overall returns they are aiming to achieve.
Jackie Bowie is group chief executive officer of financial hedging solutions firm, JCRA
