The Many Impacts of Contract Tenor on Hedge Performance

Foreign currency exposure can introduce an element of surprise if left unattended. This is true for international portfolio managers, global fund distributors, corporations and even world travelers.

While avoiding such uncertainty may be more challenging for those of us planning our next trip abroad, the investment management community has tools available to implement foreign exchange (FX) hedging solutions that help mitigate the impact of FX fluctuations.

The vast majority of FX hedging strategies (both active and passive) are implemented using currency forward contracts. In this context, currency forwards are negotiated in amounts that will appropriately offset existing exposure to foreign currencies arising from underlying foreign currency denominated positions. For long positions, the notional amount of the underlying exposure represents the currency sold “short”, and the “long” currency represents the base currency of the fund (the opposite would be the case to hedge a short currency exposure).

Unlike spot transactions, forwards are often utilized when there is no intention to take physical delivery of the currencies in the transaction. Like any hedge, the objective is for the gain (or loss) of the forward position to offset the implicit loss (or gain) of the underlying FX exposure attributable to the underlying foreign position. If done properly, the net effect of the translated position and the hedge will isolate the local return of the position, thereby negating the FX risk.

Due to the structure of forward contracts, it is important to select the appropriate tenor to settle these gains or losses, for example daily, 1 month, 3 months, 6 months or longer. Although some managers prefer to keep the operational and trading process simple, (minimizing settlements, cashflows and trades) by choosing longer dated tenors, we assert that shorter tenor forwards (typically 1 month) may optimize performance and lower risk. We outline the reasons here:

1. Credit Risk:

When a position is “rolled forward” prior to expiration, the gains or losses of an FX forward hedge are typically settled on a net basis and the interim P&L is considered unrealized during the life of the contract. If the “out of the money” party then experiences an adverse credit event between the trade date and settlement date of the trades, the unrealized P&L is at risk of default.

Shorter tenor contracts create more frequent cash flows, thus reducing the probability of default. In addition, more frequent settlements often result in smaller cash flows, thereby reducing settlement risk.

2. Interest Rate Risk

By their nature, forward hedges must account for the difference in local interest rates between the two currencies
traded. In an efficient market, an investor cannot borrow in a low interest rate country (based on local risk-free rates), convert their cash to another currency where they can then invest at higher local riskfree rates, and hedge the FX risk to yield risk-free returns. To avoid risk-free arbitrage, either a discount or premium is applied to the price of the FX forward relative to the spot rate to reflect the “interest rate differential”

The discounts and premiums are determined based on the risk-free rates of each market at the time of the trade. A forward will lock in the current differential for the full duration of the contract. If there is a favorable (or unfavorable) change in one or both interest rates, the hedge performance will reflect both FX rate changes and interest rate changes. This unintended interest rate risk can be mitigated by “resetting” your forward prices to reflect current market conditions more regularly through shorter tenor contracts.

3. Transaction Costs:

In a world of uniform liquidity and flat yield curves, investors could transact forwards over any tenor at
equal cost. More specifically, rolling a 1 month forward 12 times per year would cost the same as rolling a 6 month forward twice a year. However, liquidity is not uniform and will impact the costs of trading. Higher liquidity tends to be on
the shorter end of the tenor spectrum (i.e., 3 months and shorter), as most investor demand and market supply is anchored around these tenors.

Furthermore, BASEL III regulatory changes are underway which will impact the way banks capitalize their balance sheets. Unsecured FX positions will require banks to set aside a higher level of regulatory capital – assets that otherwise could have been reinvested for returns. As one might expect, the higher the uncertainty of these unsecured positions, the greater the capital requirements. Simply put, banks pricing longer dated forwards will be required to post more capital, and thus demand higher returns in the form of wider spreads.

4. Unrealized P&L:

Finally, we tackle the impact that the unrealized P&L has on the performance of the hedge. The hedged performance equals the translated value of the foreign exposure to the base currency plus the P&L of the hedge. The unrealized P&L will remain equivalent to a cash position until the P&L is realized and is either a) available to reinvest in the underlying position or b) necessary to divest from the underlying position to cover a hedge loss.

This cash position will either enhance or drag performance depending on the combination of gain or loss of the hedge and the performance of the underlying position. For example, if the local currency were to depreciate by 5%, the base currency equivalent of the exposure would be worth 5% less (due to the currency translation), but would be offset by a gain in the hedge of 5%, making the hedged position whole. As a result, the hedged exposure would then be comprised of 95% underlying exposure and 5% unrealized P&L (uninvested cash equivalent).

We refer to the percent of the hedged position exposed to the underlying as the “investment ratio”, in this case 95%. The investment ratio is equal to the percent of the subsequent period’s return that the hedged position will capture. For example, if the local exposure subsequently appreciates by 1.00%, the hedged position would only appreciate by 0.95% due to being under-invested relative to local investors.

In an operationally frictionless world of unlimited liquidity, one would achieve optimal hedge performance and minimize both credit and interest rate risk by rolling hedge positions daily. Daily rolls would allow for the most frequent settlement of gains and losses, ensuring that the investment ratio is reset to 100% as often as possible. Daily rolls would also allow investors to re-price their hedge positions to reflect the most current interest rate differentials and avoid unintended interest rate risk.

We don’t live in this hypothetical world, however, and must account for the realities of how markets trade and the limited resources we have available to manage the daily workflows required to support a hedging process. What is to be taken from the above fictional example is that when hedging foreign currency exposures, shorter tenor hedge contracts may help to avoid many unintended and often unexpected risks that forward contracts may introduce. One should take into account particular program objectives and client considerations, but we generally believe that shorter tenor contracts help manage the balance between optimizing performance and minimizing the various costs and risks of hedging.