The global currency market is arguably the most important financial market. It is the bedrock of both domestic and internation commercial activity. Many investors (be they advisors or corporates) find themselves grappling with the intricacies of controlling and managing their FX risk in a way they themselves sometimes admit is akin to ‘flying blindly’. In this note we introduce our active FX hedging programme that allows corporates, investors and other groups to take control of their FX risk.
International investors and multinational corporations commonly have assets or liabilities denominated in currencies other than their base currencies—payables, receivables or foreign denominated debt and investments. The income statement of such corporations is generally subject to currency exchange rate risk. Namely, the balance sheet carrying values of those assets or liabilities must be adjusted at the end of each accounting period to reflect the latest exchange rate conditions. This effect is considered a transaction gain or loss giving rise to an adjustment to reported income.
Most companies, view this currency effect as separate to their core business, and may hedge using currency forwards. For asset exposures, the company would sell the non-base currency forward, conversely, for liabilities, the company would buy the non-base currency forward. In either case, the size of the forward position would correspond to the number of currency units associated with the asset or liability being hedged.
Structuring these hedges, generates a gain or loss on the forward contract that would be commensurate with the market effects on to the asset or liability being hedged. You would hope to gain on a forward contract when the exchange rate fosters a transaction loss on the asset or liability. On the other hand, one expects to lose on a forward contract when the market effect enhances earnings.
The net effect of putting an exact hedge in place is to make the base value of any assets or liabilities immune to fluctuations in the currency markets. Systematic tactical FX hedging that uses currency factor strategies (for example currency carry, currency momentum and currency value) is a way of protecting an existing or anticipated position from an unwanted move in an exchange rate. It does not eliminate the risk of loss completely but helps to manage currency exposure better.
There are four possible outcomes to a hedge: (1) Selling a forward contract at a premium over the spot price is a benefit. (2) Selling a forward contract at a discount is a cost. (3) Buying at a premium is a cost. (4) Buying at a discount is a benefit. In other words, hedging does not necessarily impose a cost. Specifically, in cases (1) and (4), the forward points serve to reward companies that can hedge under these conditions. Forward points may either work for you or against you, but you’re limited to what the market offers. It is sort of a “take-it-or-leave-it” proposition without an FX forecast engine to help decide whether to hedge or not. Overall, everyone must answer the question for themselves. Some might prefer to hedge because of their risk aversion. Another person might not mind the currency risk. It all depends on a variety of factors, including the costs, investment needs, risk aversion, and so on.
Enhancing hedging outcomes relies on the capacity to predict foreign exchange movements, in this regard, C8’s proprietary FX-Combination model portfolio powers the effectiveness of its hedging tool. The FX models encompass macroeconomic and technical factors. For example; relative inflation and growth, change in stock and bond prices, change in commodity prices, enhanced purchasing power parity, intrinsic currency indices are used to evaluate the relative strength of a trend.
Benefits of FX Hedging
Simple and easy to understand: typically implemented through futures, forwards or currency swaps – linear products.
Risk Mitigation: FX hedging helps mitigate the risks associated with currency fluctuations. By employing hedging strategies, businesses can protect themselves from adverse movements in exchange rates, ensuring more predictable cash flows and financial stability. Stability: Budgeting and Planning: Hedging provides a level of certainty in budgeting and financial planning. Businesses with international operations can reduce the impact of currency volatility on their budgets, making it easier to set realistic financial objectives and projections. Protecting Profit Margins: For companies engaged in international trade, currency fluctuations can impact profit margins. FX hedging allows businesses to safeguard their profit margins by locking in exchange rates. Facilitating Strategic Decision-Making: A well-executed FX hedging strategy enables businesses to make strategic decisions without being overly exposed to currency movements. This includes making investments, expanding into new markets or entering long-term contracts with greater confidence in financial outcomes. Low transaction cost: Liquid FX forwards operate with tight spreads in G10. Funding: Sometimes it is difficult or costly to fund in local currency so you must go the “majors” – mainly USD – to fund your local business, thus opening FX risk.
Active FX Hedging
Potential for Higher Returns: Unleash the power of active management to potentially benefit from currency movements, boosting returns beyond what a passive approach can offer. Adaptability to Market Conditions: Stay ahead of the game by adjusting strategies in response to changing market conditions – seizing opportunities and mitigating risks promptly. Customization: Tailor your strategies to your specific risk tolerances and business needs, ensuring a personalized approach that fits your exact requirements. Dynamic Hedging: Active management means dynamic hedging, actively shielding your portfolio against adverse currency movements. Experience: The team has decades of experience in the currency markets both with major banks and funds. Deep Expertise: boasting a profound understanding of FX markets, modelling, and the intricate risks that multinational corporations and funds face. Machine Learning Models: Harness the power of machine learning and identifies behaviour in historical data that drives future currency movements. Statistical Models: get under-the-hood of the relationships between currencies and key economic factors, providing a comprehensive analysis. Tailored Solutions: No one-size-fits-all approach – use the tool to create customized FX hedging solutions that align precisely with your business’s unique needs.
Viking Harbour has isolated it’s powerful FX models into a standalone product for the benefit of those looking for help to manage FX risk. These models have been battle-hardened over decades and continuously improved over that period. These cutting-edge tools help advisors and others to create simply but effective FX hedging solutions for their own circumstance. Freeing up advisors to concentrate of what they do best, knowing that their FX positions are managed efficiently and optimally.
