Sterling has been relatively volatile of late! Sharp movements always stimulate a debate around hedging, but for those that are already hedged, volatility presents itself in the mark to market of their derivatives.
In the past couple of months we have had many discussions with our clients about what the choices are when faced with hedges that are deeply in the money. First and foremost, it is important to note that when hedges are deeply in the money, the value of the underlying assets will have declined. We should always remember that one of the primary objectives of hedging is to minimise the impact of FX volatility (among other financial risks) and not to speculate.
Most of the discussions that we have held are with USD funds that own EUR or GBP assets, as well as with EUR funds that hold GBP assets. Hedging sterling either over the last few months or the last few years has clearly been worthwhile. Since the end of March of this year through to the end of August, sterling depreciated by 4.8% (from 1.1615 to 1.1058) against the euro. Since the decision for the UK to leave the EU back in 2016, the pound has dropped by 16%. This means that GBP hedges, whether placed during the last six months or back in 2016, have significant positive mark to market values.
These dramatic gains have triggered conversations around two subjects. The first question is how to ‘lock in’ this value so that if sterling rallies again the positive valuations do not erode or even turn negative. The second is how this value can be returned to investors.
To restructure or to re-strike?
In the vast majority of cases the instrument of choice for fund level hedging is the FX forward. FX forwards give the best protection rate at the lowest cost but lack flexibility. So, when addressing the topic of how to ‘lock in’ value while still remaining protected, the discussion should be centred on restructuring the forwards into more flexible instruments such as FX options. Restructuring will need the existing FX forwards to be unwound by executing equal and opposite trades, after which more flexible hedges can be purchased. Vanilla options give the necessary protection while giving the fund the ability to take advantage of any sterling rallying. The disadvantage here is that these require the payment of an upfront premium, and therefore are not seen as a long-term solution to fund level hedging.
The other consequence of unwinding existing hedges that are in the money revolves around releasing their cash value. One way to achieve this is to “re-strike” the instrument rather than restructuring it completely. Re-striking a forward entails changing the exchange rate in order to return the positive mark to market to the investor. However, this cash is not due until the settlement date of the FX forward and there are usually costs associated with releasing the cash ‘early’. Different banks take different approaches to pricing this early release, and it is important to ensure that the charges are transparent and clearly understood.
For those who hedge foreign currency assets at fund level but are not interested in restructuring or re-striking: keep calm and carry on! Hedging will always give rise to mark to market volatility but at the same time it is reducing the overall risk of the fund and the impact on the NAV.
For more information, please contact Chris Towner, Director at Chatham, at email@example.com.