FX Hedging – How It Works

In international investment, currency risk is a significant concern, which leads to the concept of FX hedging.

When investors from one country, such as Japan, buy foreign bonds, they must exchange their domestic currency (JPY) for another (such as USD or EUR).

This exposes them to foreign exchange (FX) risk, which many prefer to avoid.

We look at how FX hedging works and how it’s implemented by institutional traders to mitigate this risk.

Key Takeaways – FX Hedging

• FX Hedging Importance:
  • Example: Japanese investors buying USD or EUR bonds face FX risk.
  • To manage this, they use FX hedging, typically for three to twelve months, to assess the risk/return profile of their bond investment after considering FX risk.
  • The cost of FX hedging is influenced by factors like monetary policy divergences and yield curve shape.
• Hedging Instruments & Execution:
  • Institutional traders use instruments like forward contracts, futures, options, and currency swaps to hedge currency risk.
  • The process involves risk assessment, selecting the appropriate hedging instrument, executing the hedge, continuous monitoring, and making necessary adjustments.
• Cross-Currency Basis Impact:
  • The cross-currency basis represents the discrepancy in currency pair pricing due to interest rate differentials.
  • It affects the cost of FX hedging, with a positive basis increasing costs and a negative basis reducing them.
  • Factors like supply and demand, credit risk, and monetary policy can influence the cross-currency basis.

The Need for FX Hedging

When Japanese investors buy foreign bonds, they inherently take on FX risk. To manage this risk, they typically hedge their FX exposure for a period between three and twelve months.

This time frame is considered sufficient to assess the risk/return profile of their bond investment after accounting for FX risk.

Example: Trading US Treasuries

Consider a Japanese trader looking at betting on 10-year US Treasuries.

What they see is the cost of the investment after accounting for the costs of hedging USD/JPY for the next 12 months.

The attractiveness of the investment is significantly influenced by the FX hedging costs.

Factors Influencing FX Hedging Costs

FX hedging costs can make US Treasuries either expensive or cheap for Japanese investors.

These costs are influenced by:

• Monetary Policy Differentials: The difference in monetary policies between the Federal Reserve (Fed) and the Bank of Japan (BOJ) has a big role. FX hedging costs depend on the rate hiking or cutting cycles of these institutions.
• Shape of the Yield Curves: The shape of the yield curves in the two countries also strongly influences the yield benefit in investing in foreign 10-year bonds.

How Institutional Traders Implement Currency Hedges

Institutional traders use various financial instruments and strategies to hedge currency risk.

The process involves creating a financial strategy that will protect their investments from adverse currency movements.

Below is a detailed explanation of how institutional traders put into place currency hedges, focusing on the instruments and execution.

Instruments Used for Currency Hedging

Forward Contracts

A forward contract is a private agreement between two parties to buy or sell a currency at a future date for a price agreed upon today.

Institutional traders use forward contracts to lock in an exchange rate for a future transaction, effectively hedging against potential adverse currency movements.

Futures Contracts

Similar to a forward contract, a futures contract is an agreement to buy or sell a currency at a future date for a price agreed upon today.

Unlike forward contracts, futures are standardized and traded on exchanges.

Traders use futures contracts to hedge currency risk by agreeing to a set exchange rate for a future transaction.

Options Contracts

An options contract gives the holder the right, but not the obligation, to buy or sell a currency at a predetermined price before or at the expiration date.

Options provide traders with a way to hedge currency risk while retaining the potential to benefit from favorable currency movements.

Currency Swaps

In a currency swap, two parties exchange currencies for a certain period and agree to reverse the transaction later.

Currency swaps are used by institutional traders to hedge long-term currency exposure.

Execution of Currency Hedging

Assessment of Exposure

Traders first assess their currency exposure to understand the extent of the risk.

They analyze the potential impact of currency movements on their investments and positions and determine the appropriate hedging strategy.

Selection of Hedging Instrument

Traders choose the most suitable hedging instrument based on their risk assessment.

The choice depends on factors like the size and duration of the investment, and the trader’s risk tolerance.

The cost of the trade also, of course, matters.

Implementation of the Hedge

Traders execute the chosen hedging instrument.

For example, they might enter into a forward contract to sell a foreign currency at a future date, effectively locking in the current exchange rate.

Monitoring and Adjustment

Traders continuously monitor the market and their hedge positions.

They make adjustments as necessary to ensure the hedge remains effective in mitigating currency risk.

Closure or Exit

At the end of the hedge period or when the underlying exposure is eliminated, traders close out the hedge position.

For example, they might execute the opposite transaction in a forward contract to nullify the hedge.

Options will expire automatically.

For ITM options, monitor how delivery might impact your portfolio.

Understanding the Cross-Currency Basis

What is Cross-Currency Basis?

The cross-currency basis refers to the discrepancy that may exist in the pricing of a currency pair in the foreign exchange market when considering the interest rate differentials between the two currencies.

It is essentially the additional cost or bonus of borrowing one currency relative to another and is expressed as a basis point spread relative to the foreign exchange forward rate.

How Does It Work?

In a perfectly efficient market, the interest rate parity theory suggests that the cost of borrowing in different currencies should be the same once the foreign exchange rate is taken into account.

However, markets are not always efficient. Various factors can lead to a discrepancy between the theoretical and actual costs of borrowing in different currencies.

This discrepancy is referred to as the cross-currency basis.

Example

Suppose a Japanese investor wants to borrow in USD rather than JPY.

If the cross-currency basis is negative, it means that it is more expensive for the investor to borrow in USD than in JPY after considering the foreign exchange rate.

Conversely, a positive cross-currency basis would mean that it is cheaper to borrow in USD than in JPY.

Factors Influencing Cross-Currency Basis

Supply and Demand for Currencies

A high demand for a particular currency relative to its supply can lead to a negative cross-currency basis for that currency.

Credit Risk

Differences in credit risk between two currencies can influence the cross-currency basis.

Liquidity Constraints

Limited liquidity can lead to a wider cross-currency basis spread as borrowers may be willing to pay more to access a particular currency.

Monetary Policy

Divergent monetary policies between two countries can also impact the cross-currency basis.

Impact on FX Hedging

The cross-currency basis is important for investors and companies involved in foreign exchange hedging.

A negative cross-currency basis for a particular currency pair implies that hedging currency risk for that pair will be more expensive, impacting the overall cost and potential return of the investment or business operation.

Challenges and Risks of FX Hedging

FX hedging’s challenges and risks:

• Cost: Hedging can be expensive, especially if the market moves in the opposite direction of what was anticipated. The costs associated with setting up and maintaining hedging strategies can erode potential benefits.
• Forecasting Errors: Incorrect predictions about future exchange rate movements can lead to ineffective hedging.
• Liquidity Risk: Some hedging instruments might not be easily tradable, leading to liquidity issues.
• Basis Risk: The risk that the hedging instrument and the exposure being hedged do not move in opposite directions as expected.
• Operational Risks: These include risks related to failures in internal processes, systems, misunderstandings, human errors in executing hedging strategies, or from external events.
• Imperfect Hedges: It can be challenging to design a perfect hedge. There might be mismatches in the maturity, amount, or even the exact nature of the exposure versus the hedging instrument.
• Counterparty Risk: There’s a risk that the counterparty to a hedging instrument, like a forward contract, might default on their obligations.
• Over-Hedging: There’s a risk of hedging more than the actual exposure, which can lead to unnecessary costs and potential losses.

Example of the Importance of Hedging FX Risk – The Fall of the Bond Corporation

In the 1980s, Australian businessman Alan Bond expanded his business empire by acquiring breweries and other assets.

He borrowed heavily in US dollars, believing that the Australian dollar (AUD) – the currency he earned his income – would remain strong.

However, when the AUD depreciated against the USD, Bond’s debt in AUD terms ballooned.

An adverse currency move of that sort is essentially like a big surge in interest rates on the debt.

Since he didn’t hedge his FX exposure, the increased debt burden, combined with other financial troubles, led to the collapse of the Bond Corporation in 1991.

Bond’s failure to hedge against currency fluctuations was a significant factor in his financial downfall.

FAQs – FX Hedging

What is FX hedging and why is it important for institutional traders?

FX hedging, or foreign exchange hedging, refers to the strategies or tools used by companies and institutional traders to protect themselves from the risk associated with fluctuations in foreign currency exchange rates.

When companies or investors conduct business or invest internationally, they are exposed to the risk that the currency they are dealing in will fluctuate in value compared to their home currency.

It’s a form of uncompensated risk.

These fluctuations can lead to unexpected losses.

For institutional traders, FX hedging is important because:

• Profit Protection: It helps in protecting profits made in foreign investments.
• Budgeting and Forecasting: Companies can set budgets and make forecasts without the concern of currency fluctuations distorting their projections.
• Competitive Advantage: By effectively managing currency risk, companies can gain a competitive advantage over competitors who do not hedge.
• Stability: It provides stability to earnings and financial results, which is especially important for publicly traded companies.

How does FX hedging work in mitigating currency risk for international investments?

FX hedging involves taking an offsetting position in a currency derivative, such as a forward contract or an option, to counteract potential losses from adverse currency movements.

For instance:

• Forward Contracts: An institutional trader can enter into a forward contract that locks in the exchange rate for a future date. This means that they know exactly how much of their home currency they will receive when they convert the foreign currency in the future, regardless of how the market exchange rate fluctuates.
• Options: Currency options give the holder the right, but not the obligation, to exchange a currency at a predetermined rate. This can be useful if the trader believes the currency might move against them but also wants to benefit if it moves in their favor.

By using these instruments, traders can ensure that even if the currency moves against their position, the loss on their original investment is offset by the gain on the hedging instrument.

What are the different instruments used by institutional traders for FX hedging?

Institutional traders use a variety of instruments to hedge against currency risk:

• Forward Contracts: Agreements to buy or sell a set amount of a foreign currency at a specified price for settlement at a future date.
• Currency Options: Contracts that grant the right (but not the obligation) to buy or sell currency at a specified exchange rate during a specified period.
• Currency Futures: Contracts to buy or sell a specific currency amount at a set price, on a set date in the future.
• Currency Swaps: Agreements to exchange one currency for another at a specified rate and then to reverse the exchange at a later date.
• Money Market Hedges: Involves borrowing and lending activities in two different currencies to lock in the home currency value of a future foreign currency cash flow.

How do institutional traders assess and implement FX hedging strategies?

The assessment and implementation of FX hedging strategies involve several steps:

• Risk Identification: Determine the type and magnitude of currency exposure. This can be transaction exposure (short-term), translation exposure (balance sheet related), or economic exposure (long-term impact on company value).
• Objective Setting: Decide on the goal of the hedging strategy, whether it’s complete elimination of risk, partial hedging, or something else.
• Strategy Selection: Choose the appropriate hedging instrument based on the nature of the exposure, the market conditions, and the company’s risk tolerance.
• Execution: Implement the chosen strategy using the selected financial instruments.
• Monitoring and Adjustment: Continuously monitor the effectiveness of the hedging strategy and make adjustments as necessary based on market conditions and the company’s exposure.

What is the impact of monetary policy differentials on FX hedging costs?

Monetary policy differentials refer to the differences in interest rates and monetary policy stances between two countries.

These differentials can have a big impact on FX hedging costs.

When one country has a higher interest rate than another, its currency is often seen as more attractive to investors, leading to an appreciation of that currency.

This can affect the forward rates and the cost of hedging.

For instance, if a trader is hedging against a currency that is expected to appreciate due to higher interest rates in that country, the forward rate may be set at a premium, making hedging more expensive.

How does the shape of the yield curve influence FX hedging costs?

The yield curve, which plots the interest rates of bonds of equal credit quality but different maturities, can influence the forward rates and, consequently, the cost of FX hedging.

If the yield curve is upward-sloping (normal yield curve), it indicates that long-term interest rates are higher than short-term rates.

This can lead to a forward premium for currencies of countries with steeper yield curves.

On the other hand, an inverted yield curve, where long-term rates are lower than short-term rates, might result in a forward discount for the currency of that country.

The shape of the yield curve can, therefore, influence the cost of forward contracts and other hedging instruments.

How do institutional traders monitor and adjust their FX hedging strategies?

Monitoring and adjusting FX hedging strategies is a continuous process:

• Performance Tracking: Traders regularly track the performance of their hedging strategies against benchmarks to determine their effectiveness.
• Market Analysis: Continuous analysis of market conditions, including interest rates, economic indicators, and geopolitical events, can influence currency movements.
• Risk Assessment: Regularly reassessing the company’s currency exposure and risk tolerance to ensure the hedging strategy is still aligned with the company’s objectives.
• Feedback Loop: Using the insights gained from performance tracking and market analysis to refine and adjust the hedging strategy as needed.

Can FX hedging guarantee protection against all currency-related losses?

No, FX hedging cannot guarantee complete protection against all currency-related losses.

While it can significantly reduce the risk of adverse currency movements, there are still factors like basis risk that can impact the effectiveness of a hedging strategy.

It also depends on the instrument. For example, options don’t just have the price (delta) component, but a volatility component to them.

The goal of hedging is not to necessarily eliminate risk entirely but to manage and reduce it to an acceptable level.

How does the cross-currency basis affect the cost of FX hedging for institutional traders?

The cross-currency basis refers to the deviation from the covered interest rate parity.

This implies that the forward exchange rate should be a pure reflection of the interest rate differential between two currencies.

When there’s a positive cross-currency basis, it means that borrowing in one currency and lending in another via the FX swap market is more expensive than doing so in the cash market.

For institutional traders, a positive cross-currency basis can increase the cost of FX hedging as it implies a premium on the forward rate.

Conversely, a negative basis might reduce the hedging cost.

The cross-currency basis can be influenced by factors like supply and demand imbalances in the FX swap market, regulatory changes, and liquidity constraints.

How do institutional traders monitor and adjust their FX hedging strategies?

Monitoring and adjustment are integral to the success of FX hedging strategies:

• Continuous Monitoring: Traders keep a close eye on their hedging positions, comparing them against benchmarks and assessing their effectiveness.
• Regular Reviews: Periodic reviews of the hedging strategy are conducted to ensure it aligns with the institution’s risk tolerance and objectives.
• Market Analysis: Keeping abreast of market conditions, geopolitical events, and economic indicators helps traders anticipate potential currency movements.
• Feedback Mechanisms: Insights from monitoring and market analysis are used to refine and adjust strategies as needed.

Can FX hedging guarantee protection against all currency-related losses?

No, FX hedging cannot provide an absolute guarantee against all currency-related losses.

Its primary purpose is to reduce the risk of adverse currency movements, not to eliminate it entirely.

Factors like forecasting errors, sudden geopolitical events, and market anomalies (e.g., basis risk) can still impact the effectiveness of a hedging strategy.

How does the cross-currency basis affect the cost of FX hedging for institutional traders?

The cross-currency basis is the difference between the market exchange rate and the rate derived from the interest rate differentials of the two currencies involved.

A positive or negative basis can influence the cost of hedging:

• Positive Basis: Implies that it’s more expensive to borrow in one currency and lend in another using the FX swap market than it would be in the cash market. This can increase the cost of hedging.
• Negative Basis: Suggests that it’s cheaper to borrow in one currency and lend in another using the FX swap market. This can reduce the hedging cost.

Factors like supply and demand imbalances, regulatory changes, and liquidity constraints in the FX swap market can influence the cross-currency basis.

Conclusion

FX hedging is a strategy commonly employed by institutional traders, especially when investing in foreign bonds.

Understanding the factors that influence FX hedging costs, such as monetary policy divergences and the shape of yield curves, is important for effectively managing FX risk.

By doing so, investors can better assess the true cost and potential return of their international bond investments.