How a thoughtful FX strategy
can give Fund Managers a
competitive edge
Executive
summary
Each alternative investment fund takes a different approach to its
investment strategy, but the ultimate goals are similar: to deliver
absolute returns for investors in an increasingly competitive and
regulated marketplace. The fund’s unique signature is in how the
Fund Manager approaches investments, raises capital, and manages
exposure across markets.
These are the challenges inherent in managing FX exposure, and we
will demonstrate the importance of taking a proactive approach to
managing FX risk.
In this paper we will discuss:
The impact of volatility on foreign investments
Understanding the cost of your FX
Why does FX strategy matter?
Reasons to consider working with an FX counterparty
Guidance for choosing an FX counterparty
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Just as general hedging policies protect against risk in equity markets,
we believe a thoughtfully planned and executed FX strategy can help
a fund to attract new investors, improve cash flow, protect against
volatility and, in some cases, generate alpha.
2
Introduction
In a global economy with highly connected financial markets, greater
opportunities exist for cross-border investment, even if investing in
foreign currency as an asset class is not part of the fund’s strategy.
To take advantage of these opportunities and develop approaches
in line with the fund’s goals, we believe that Fund Managers need
to understand the foreign currency markets – the risks and the cost
implications – and should consider the management of foreign
exchange (FX) exposure in the context of their overall investment
strategy.
Without a sound FX strategy, a fund may be putting its investments
at risk or falling short of its fiduciary duties.
3
The impact of volatility on foreign investments
In recent years, volatility in the financial and
FX markets has been tempered by central
banks’ monetary policies, with quantitative
easing (QE) policies and monetary expansion
providing liquidity that banks could not. As
monetary policies normalize, following the end
of monetary expansion and QE in developed
markets, it is widely expected that increasing
interest rates could lead to further volatility in
the financial markets.
Some analysts are beginning to question the
stability of ‘safe-haven’ currencies. Even prior
to the unpegging of the Swiss Franc (CHF)
at the beginning of this year, the change in
value of CHF against the US dollar for the
twelve month period ending November 2014
was more than eleven percent. The following
table demonstrates that the Swiss Franc was
part of a norm rather than an exception; these
majors proved equally turbulent against the
dollar over the same twelve month period:
20.00%
18.00%
16.00%
Volatility against USD
14.00%
12.00%
10.00%
8.00%
6.00%
4.00%
2.00%
0.00%
EUR
One month
1.54%
Three months
5.98%
Six months
10.40%
One year
12.31%
GBP
2.24%
5.78%
9.70%
9.70%
CHF
1.37%
5.68%
9.47%
11.33%
JPY
4.94%
13.30%
17.29%
17.32%
CAD
1.65%
4.92%
7.27%
7.87%
Calculated using 2014 interbank rates, percent change versus USD from beginning to end of period noted. One month:
November 1-30. Three months: September 1-November 30. Six months; June 1-November 30. One year: December 1,
2013 to November 30, 2014.
Increasing volatility makes taking charge of FX
more critical for Fund Managers working with
international investment.
Having more visibility into rates and trends,
and understanding strategies to mitigate
risk and protect against fluctuation, can save
money and time, giving a Fund Manager a
competitive edge in a globalized market.
4
Understanding the cost of your FX
In many cases, Fund Managers trust their
prime brokers or custodial banks to manage
their FX exposure. For funds with little or
no previous exposure to foreign exchange
markets, this presents a straightforward
solution to the challenge and complexity
of forming a dedicated FX strategy. A more
experienced Fund Manager may even be
aware of FX impacts but may not find handson management to be a practical or effective
solution.
There are pitfalls and opportunities in a
dynamic market for funds with FX exposure,
whether from foreign investments or from
working with foreign investors. High collateral
requirements and assigning cash to an FX
hedge can sometimes tie up significant
capital that could otherwise be working more
effectively within the fund. In addition, the cost
of repatriating funds from foreign investments
or of managing local currency payments from
foreign investors can affect returns.
A US-based investor buy €1 million in German bonds on 1 October 2014, with the intention
of selling them on January 1st 2015. With no FX hedge in place, even with a positive bond
performance, the investor is risking diminished profits:
The bonds appreciate by 10%, but the Euro declines in value by 4%.
Original Asset Cost
Unhedged,
10% asset appreciation
EUR
New Asset Value
Rate
USD
EUR
Rate
USD
Investment/return
€1,000,000
1.2626
$1,262,600
€1,100,000
1.2125 $1,333,750
Absolute gain/loss
€100,000
$71,150
% Gain/loss
10.00%
5.60%
The investor realizes a gain of €100,000, but only $71,150 in USD. Even though the asset has
appreciated by 10%, his profit is only 5.6% because of the decline of the Euro.
Managers often do not question or examine
the fees they are paying for FX, assuming that
execution, strategy and planning come as part
of a bundle of services offered by custodian
banks, prime brokers or other counterparties.
These fees, particularly for smaller funds,
might seem like sunk costs with uncontrollable
spreads.
Fearing the possible impact on other services
provided by their counterparties, or simply
lacking the time or manpower to make a
change, Fund Managers may be reluctant to
ask, “What is my FX costing me?”
Leaving this question unanswered is too often
the status quo and poses a risk to the fund
and the investors.
5
Why does FX strategy matter?
Conducting a periodic review of a fund’s
currency impacts with a prime broker,
a custodial bank’s FX strategist or an
independent FX advisor could uncover
hidden costs, missed opportunities or areas
for savings on spreads and hedges.
protection against volatility. At the very least,
a Fund Manager needs visibility of the rates,
exposure and transaction fees in order to
better plan for impact.
With an understanding of FX exposure and
the cost implications for execution, a manager
can determine how active an approach to
take for the fund’s benefit, aligning it with the
fund’s investment philosophy.
Taking control of FX exposure at the portfolio,
treasury and investor level can save money
and time. It can also uncover opportunities and
strategies for improvement in performance.
More active FX management can generate
alpha and improve cash flow; a less active
approach can mitigate risk and provide
Furthermore, taking control of FX costs, and
being able to leverage FX hedging strategies,
could give a fund an edge in raising capital
from new investors.
Consider instead if the US-based investor had hedged the initial €1 million investment by
purchasing a €1 million Forward Contract at 1.2626:
Original Asset Cost
Hedged,
10% asset appreciation
EUR
Investment/return
Rate
New Asset Value
USD
EUR
1.2626 $1,262,600
€1,000,000
Rate
€1,100,000 Hedged
€1,000,000
Unhedged
€100,000
Absolute gain/loss
% Gain/loss
USD
$1,383,850
1.2626 $1,262,600
1.2125
$121,250
$121,250
10.00% 9.60%
By hedging the initial €1 million position, the investor would have protected his original
investment at the October 1st Spot Rate of 1.2626. The €100,000 gain would have been
realized at the January 1st Spot Rate of 1.2125, netting $50,100 more than if the entire
investment had been unhedged.
The preceding examples are hypothetical, and we have the benefit of using historical data for reference. An FX counterparty can
help devise a strategy for managing currency risk that is customized to the investment philosophy, market context, treasury and
portfolio, as well as the investor’s needs, expectations and risk appetite.
6
Reasons to consider working with an FX counterparty
An argument can be made for keeping FX
services with a prime brokerage or custodial
bank, particularly if the counterparty has FX
experience. Such an approach gives the fund
uniform reporting as well as a single point
of contact. In some cases, the fund may be
able to leverage the multi-service relationship
for more favorable pricing and credit terms
relative to the fund’s volume. Furthermore, a
long-term relationship can be valuable in a
dynamic investment market.
On the other hand, an independent FX
expert can provide unbiased risk assessment
with tailored market insights that can reveal
innovative strategies or hedging opportunities,
as demonstrated in the following scenarios,
and increase a fund’s operational efficiency.
With a single provider offering FX services as
well as credit, equity trading and placement, or
managing deposits and disbursements, there
is little opportunity for the provider to source
alternative points of view or explore different
strategies, and little incentive for the provider
to be transparent or competitive with respect
to FX rates.
7
Guidance for choosing an FX counterparty
Consider the suite of products, services and solutions offered.
A counterparty who understands the FX markets
can create a portfolio of services customized to
the fund’s goals, requirements and exposure. In
addition to rate transparency and timely, secure
execution, the solutions should also include
market insights and analysis to leverage FX
trading strategies that improve cash flow and/
or generate alpha.
Basic considerations should include:
• Expertise, transparency and competitive
rates. A provider should be able to
recommend and implement a range of
tactics, from traditional Spot Transactions
and Forward Contracts, to more complex
Swaps and Options, aligned to the specific
requirements, goals and risk appetite of the
fund, with full transparency of associated
margins and fees.
• Flexible and tailored credit terms. Reduced
margin call percentages or a low fixed upfront
deposit, pegged to notional value, can be
negotiated.
• Local currency solutions. Local currency
solutions for deposits from international
investors (or investment in a foreign currency
asset class), and the ability to repatriate
funds or realize return when rates favor the
exchange can give a fund more scope and
access to international capital.
• Up-to-the-minute market analysis. Depth of
knowledge of the markets the fund operates
in, coupled with institutional history and
experience, can help to contextualize trends
and uncover additional tactics.
• In-depth review and analysis of risk,
exposure and hedging policies. The FX
provider should have expertise in developing
and implementing strategies that simply
mitigate risk, as well as more active
strategies, including options and overlays,
according to the fund’s appetite for risk.
A fund seeking a complete review of
its current hedging policy might seek a
provider who can offer more dynamic
hedging solutions, either in-house or
through specialized partnerships with other
counterparties. These solutions can facilitate
truly hedged portfolios and generate alpha.
Additional services offered by specialized FX
counterparties should include:
• Aligned reporting and benchmarking. A
service plan should include customized
reporting and reconciliation packages,
allowing clients to stay up to date on OTM
positions, payables and foreign currency
cash flow at all times. These reports should
align with the fund’s regular reporting or
MTM schedules, and agreed benchmarks.
• Consultative and personalized service.An
experienced FX expert can provide unbiased,
consultative service from beginning to end,
including monitoring FX markets for best
execution.
• Licensed and regulated. Be sure your
FX counterparty has all the appropriate
regulatory licenses and compliance, to
ensure transactions are secure, transparent
and guaranteed.
8
Do your due diligence.
With every counterparty, Fund Managers need
to evaluate risks and guarantees through
due diligence and evaluation of any tactic or
service. The following example is a sketch of
an evaluation plan, to be discussed with the
FX provider:
• Review FX impacts over the preceding
year, including a rigorous analysis of the
performance success of hedging, option,
and forward strategies.
• Evaluate the fund’s existing hedging policies,
in light of recent performance and market
trends. The FX counterparty should operate
within these policies, and alongside other
counterparties.
• Align tracking and reconciliation reports to
MTM and OTM calls. Ongoing performance
reporting and independent validation of rates
against agreed benchmarks are another
important part of the reporting.
• Realign the fund’s goals, needs and exposure
to current and expected market conditions.
9
Remember these key questions when exploring FX
counterparty solutions.
What settlement credit terms can I expect?
Credit terms will vary and should be flexible and tailored to the specific needs of your fund.
You could negotiate reduced margin call percentages, or a lower fixed deposit upfront. This
approach immediately improves cash flow, increasing the amount of working capital in the fund.
How are international deposits or investments in a foreign currency asset class
managed?
With an independent non-bank FX provider, deposits can be held in one currency until needed,
or until the rate favors the transaction. Your trader should be familiar with the breadth of your
currency needs, reporting schedule and timings. Having a flexible, customized solution can also
help to attract foreign investment to the fund.
Will working with a FX provider as counterparty affect my relationship to my custodial
bank or prime brokerage?
Working with an independent FX counterparty should not affect an established custodial banking
relationship. A common misconception amongst financial services businesses is that your FX
execution must be via your custodial bank or prime broker. A bank does not typically require that
the fund tie the FX business to the credit agreement or package.
Are the terms for upfront deposit requirements and OTM allowances for FX hedges
transparent for the fund and the investors?
A customized reporting and reconciliation package allows the fund administrator to stay up to
date on OTM positions, payables and foreign currency cash flow at all times. Because rates
fluctuate, transparency and independent validation of rates are paramount for managing FX
exposure. One approach would be to benchmark a fixed spread on a given currency pairing
versus the daily interbank rate. An FX counterparty should be able to develop a custom report
that displays the FX transactions to investors should they require it.
An independent FX provider with expertise in a range of fund types, such as distressed debt,
private equity, real estate or P2P lending, can help with these steps. The provider can work
alongside the Fund Manager to develop and implement tailored, innovative FX strategies for
individual investor, portfolio and corporate treasury exposure that add value.
10
Conclusions
Transparency, improved cash flow and managing volatility will
become even more important for international investors and
Investment Managers in the changing monetary environment.
Foreign currency exposure, when managed correctly, can provide
additional support for a fund’s strategy, yield improved cash flow
and even generate alpha.
The foreign currency market is the largest and most liquid global
financial market and is thus becoming a greater investment focus
for many AIFs.
Beyond investments in currency as an asset class, sound
management of currency risk associated with foreign portfolios
can help propel a growth strategy in an increasingly volatile and
competitive global marketplace.
A fund might be better able to raise capital from foreign investors
or find additional opportunities in international investment to round
out a portfolio.
Striving for greater certainty and consistency in reporting, creating
a plan for managing FX exposure and mitigating FX risk are
fundamental to a successful fund strategy.
11
About AFEX
AFEX has been a trusted business partner for global payment and risk
management solutions since 1979. We can handle every aspect of a
client’s foreign payment needs, from risk consultation to transaction
execution.
We specialize in working with Fund Managers and institutional investors
seeking global payment and risk management solutions to hedge against
volatility in currency markets. Each client works with a dedicated point of
contact to develop and implement custom strategies by understanding
the intricacies of each type of AIF.
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in a manner consistent with the best interests of its clients and in
accordance with Federal and State regulations governing foreign
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standards. To ensure that safety, we have established strict standards
of compliance with the regulations in all jurisdictions where we operate.
To learn more about our comprehensive range of foreign exchange
solutions, please call our team on +1 818 728 3853 or visit us online
at afex.com.
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