By Russel Singh, Head of FX Services – Americas region, Al Baptiste, Global Head of FX Sales and Hans Jacob Feder, Global Head of FX Services.
The rapid, unpredictable and devastating nature of Covid-19’s spread forced investors in foreign exchange (“FX”) or with currency exposure to negotiate a rocky 2020. Many reeled as the pandemic escalated uncertainty and volatility substantially across markets, often upending strategies that had benefitted from years of relatively modest price moves.
Even amid a hopeful backdrop, this year’s outlook for the FX market remains turbulent. More than a few market watchers anticipate elevated volatility and uncertainty—and a weaker dollar—over the near term, as coronavirus vaccines roll out slowly and unevenly across the globe and a number of central banks hold benchmark interest rates at, near or below zero.
And while many investors imagined they would see reduced U.S. political uncertainty, widespread Covid-19 vaccinations and an eventual global economic recovery in 2021, last year’s tumult motivated some to revisit their approach to hedging currencies. Consequently, fund administrators have seen an uptick in their currency hedging business lines, led by investors who had always hedged their currency risk—but mostly did it themselves—and those money managers who’d only hedged occasionally for strategic reasons.
In this environment, there are advantages for some investors to explore FX hedging strategies on their overseas investments. Currency overlays managed by the right fund administrator can minimize investors’ FX risk and mitigate the damage outsized adverse FX moves can cause to their positions.
Heading into early 2020, FX volatility had been falling over the preceding 10 years, reducing many real money managers’ urgency to hedge their currency risk or leading some who invested in higher-yielding currencies to hedge more opportunistically. Similarly, many alpha-seeking investors found reliable returns in carry trade strategies, even as interest rates globally trended lower. These strategies—in which investors borrow a low-interest-rate currency, such as the U.S. dollar or Japanese yen, and invest in a high-interest-rate currency, such as the Mexican peso or the Indian rupee—see more success in markets where currency prices move minimally.
Covid-19’s arrival, and the subsequent uncertainty and volatility it unleashed, prompted many currency and other investors to move their money into assets that historically retain their value amid turbulence—in this case, U.S. dollars. The shift strengthened the dollar, leading to large losses in those unhedged positions where investors had used the U.S. currency to fund their investments in higher-yielding assets or were re-patriating their gains from overseas positions.
Markets in early 2021 have calmed somewhat on the back of rising expectation for a global economic recovery and greater U.S. political and monetary policy clarity. But significant uncertainties remain, particularly concerning new Covid-19 strains and vaccine access, that could prompt more sporadic currency price jumps.
A number of FX strategists anticipate a weaker dollar this year. They see factors that typically weigh on the dollar persisting, such as barrel-scraping U.S. interest rates, heavy U.S. trade and budget deficits and expectations that recovering world trade would buoy overseas economies first. Additionally, many strategists predict investors’ return to riskier assets in search of yield during calmer market spells will also weigh on the U.S. currency.
But the pandemic’s endurance and unpredictability, alongside the complications involved with vaccinating the world, could continue to drag on global economies as they recover. These factors should bolster elevated volatility expectations.
Guarding against FX risk
Some FX investors weighing these developments are also reexamining their currency hedges. Among global FX investors—including hedge funds; fund of funds; UCITs; exchange-traded funds; private equity investors in real estate and other illiquid investment projects; and long-only, traditional asset managers—those who hedge their currency risk generally fall into three camps:
- Hedge 100%: These investors believe hedging currencies makes sense in order to remove volatility and provide clients with “pure” returns (neutralizing the effects of negative currency moves)
- Hedge 0%: These investors believe in interest rate parity over the long term, rendering FX hedging irrelevant and costly; a small subsection believes that FX risk is an important part of the investment strategy when buying an emerging market asset
- Partially hedge: These investors believe it’s possible to boost returns by hedging strategically or using a utility function of volatility versus cost (carry) of hedging; investors typically define this as an Active Currency Overlay
Recently, investors who partially hedge their currency risk have started to revisit their strategies. In addition, investors who hedge 100% are looking to outsource their currency hedging, as their existing setup has proven less effective operationally and expensive.
Although alpha seekers mostly prefer marketplace volatility, which enables them to find opportunities amid gyrating prices, a number of traditional asset managers found last year’s turbulence worrying. Many of these investors consider FX hedging to fall outside their core expertise and have decided to outsource the task to reduce uncertainty and protect their returns against the damage future spikes in volatility could cause.
Hedging FX risk as a core competency
A robust FX overlay can free up time for investors to focus on what they do best, as well as reduce costs and risks. But not all currency hedging overlays are created equal; it’s worth taking the time to find a fund administrator that brings transparency and choice to the FX hedging process and is backed by a sufficient balance sheet to absorb losses.
Look for an administrator that can guarantee currency trade execution against a comprehensive and publicly available benchmark on both spot and forward transactions, such as WM/Refinitiv FX Benchmarks, which gives investors complete transparency. Investors should also seek hedging overlays that execute trades in a competitive request-for-quote auction, a process that involves sending out trade requests to several market participants simultaneously, comparing offers and selecting the best price.
Other market participants, such as banks, offer FX overlay services. However, most banks execute clients’ trades internally, thereby electing neither to source the best price in the market nor provide much transparency on the execution. Furthermore, few offer benchmark execution on currency forwards.
Specialist asset managers also provide currency hedging programs where they take a fiduciary role. But while they trade competitively in the market, they often lack sufficient balance sheets to cover any losses they incur through a wrong hedge, leaving clients exposed.
FX hedges are designed to remove currency price movements from an investment decision, allowing investors to focus on their specialty assets. A market with higher volatility signals a greater need for hedging currency risk.
Today, large segments of the developed markets exist in negative or near-zero interest rate environments, which investors must navigate without the benefit of reliable or empirically tested models. FX strategists expect turbulent markets and a weaker U.S. dollar over the short term. As rock-bottom rates and an unconquered virus continue to fuel the kind of uncertainty that renders many assumptions and FX risk models useless, it might be time to try to make the future of currency price moves irrelevant by hedging it away.