Foreign exchange hedging is a complex topic. Each hedge has a precise structure that serves a particular need.
This paper is specifically targeted at private debt fund managers and their requirements. It introduces the key sources of FX exposure, some common methods for mitigating FX risks, and some of the challenges and choices that typically arise around that process.
Many debt funds offer finance (loans) in currencies other than the one in which they report or are denominated. As a result, they are inherently exposed to FX risk. At a basic level, any depreciation of the currency in which the asset (loan) is held versus the reporting currency will decrease the asset’s value (and related coupons) in the reporting currency. Most debt fund managers will seek to mitigate this risk via an FX hedging programme. This safeguards returns and restricts the fund’s risk profile purely to the ability of the borrower to repay the loan (credit risk).
However, the construction of such a programme is an intricate task requiring the consideration of a number of variables, not least the inevitable cost of hedging, either in credit consumption or cash. As adopting a tactical approach to mitigating FX risk in an optimal way is not typically part of a manager’s remit, in the below we have outlined the key factors debt managers need to consider.