Foreign exchange risk management has risen to the top of the agenda for many North American fund managers over the course of 2023.
A combination of rising interest rates, high inflation, geo-political uncertainty and well-documented turbulence across the banking sector has seen US dollar volatility pose a potentially mounting threat to fund managers.
Having reached a two-decade high against other major currencies in September 2022, it slid to a nine-month low in February 2023 before once again rebounding to a 10-month high in recent weeks. This, in addition to the wider macro environment, could create greater uncertainty on returns for fund managers with an exposure to foreign currencies.
While fund managers are likely to welcome the more general drop in FX volatility in recent months, it is vital that they don’t become complacent. With uncertainty set to stay, fund managers need to adapt their FX risk management strategies to stay ahead of the curve.
Hedging: a cornerstone of risk management
According to MillTechFX’s own 2023 North American fund manager FX survey, 82 percent of North American fund managers state that US dollar volatility has impacted their business.
Subsequently, fund managers are renewing their focus on hedging, with 72 percent having a formal hedging program in place. Out of the 28 percent that do not, more than half (54 percent) are considering implementing one.
Fund managers are adapting their hedging strategies to make sure this risk is managed as effectively as possible, typically hedging a higher amount of their exposure to increase their protection. MillTechFX’s survey found that the average hedge ratio was between 50-59 percent, with almost seven out of 10 (69 percent) citing this as higher compared to this time last year. This suggests that fund managers are moving to hedge more of their FX risk to protect their bottom lines from currency movements.
An interesting dynamic is that over two-thirds (67 percent) of fund managers report that the cost of hedging has increased over the past year. This means that looking ahead, fund managers should consider to balance the cost of hedging against the risk of not hedging and the potential impact this may have on their returns.
The importance of hedging collateral
One of the main challenges that fund managers face when hedging is the margin required to be posted against that position as collateral. If the initial margin no longer covers the mark-to-mark edge of a hedge, due to movements in the spot rate, the GP may be required to post additional variation margin.
Any capital posted as collateral, sitting dormant in a margin account and not invested, potentially earning higher returns, can cause a drag on fund performance. The FX risk, being mitigated with forward contracts, has been replaced with a potential liquidity risk.
It is therefore unsurprising that just under a third (30 percent) of fund managers said uncollateralized hedging was the most important aspect of their FX processes. With no margin hedging, fund managers can better forecast future cash flows as they are not at risk of daily margin calls, enabling them to focus on the core task at hand and maximizing returns.
Harnessing technology to effectively mitigate FX risk
Despite the renewed focus on managing the threat of currency movements, many fund managers still lack the necessary tools and infrastructure to mitigate this risk, with over four in 10 rating their FX set-up as below average or worst in class.
One of the main reasons for this is the persistence of manual legacy systems which can be extremely cumbersome and inefficient. FX price discovery can often involve multiple phone calls, e-mails or online platforms to log in just to get a quote from your counterparties. If its best rate wins, because the market moves by the half-second, price discovery requires a team of people calling, e-mailing and logging in simultaneously before they can collectively decide who offered the best quote.
All of this internal, manual and siloed communication is extremely inefficient, with a quarter of fund managers reporting that manual processes are the biggest challenges they face when it comes to FX operations.
It is therefore unsurprising that 78 percent of fund managers are looking into new technology and platforms to automate their FX operations.
Managing an uncertain outlook
The uncertain economic outlook may make it difficult for fund managers to plan for the future, but hedging currency risk is one of the primary ways that they can mitigate the risk posed by this uncertain climate. While there will always be some that don’t hedge their FX risk at all, many are now considering doing so to protect their bottom lines.
Looking ahead throughout the rest of 2023 and beyond, getting the right processes in now and implementing alternative technology-driven solutions that can help manage FX risk more effectively will be key in navigating the challenges that lie ahead.
Eric Huttman is the London-based CEO of MillTechFX