Hedging strategies during times of inflation

Why should funds be reconsidering their hedging strategies now? How might these strategies differ from those followed in the last few years?

“Some funds have been looking at longer-term FX hedging in the same way as they did in the early days of the Covid pandemic, when they locked in their hedging to avoid potential liquidity and pricing spikes.

“The situation in Ukraine has sparked the same concerns over liquidity and pricing; however, these concerns seemed to dissipate relatively quickly. What has remained, however, is FX rate volatility. Customers have continued to hedge where they need to in order to mitigate at least some of the pricing risk.

“Interest rate risk is not something that has featured highly on funds’ agendas over the last decade or so. But with central banks around the world raising interest rates to fight inflation, debt servicing costs have taken a greater share of cash flow.

“Not surprisingly, this has focused attention on interest rate hedging around board tables and within finance departments. This could continue to be the case, with interest rates seemingly set to carry on rising around the world over the next 12 months or so.”

What are the main types of hedges used by the different types of funds?

“When funds hedge against FX risk, they typically do so through FX forwards or FX swaps. Where funds do not hedge, they purchase or sell currency at spot.

“However, the spot market approach leaves the fund fully open to liquidity and pricing spikes due to factors out of their control when they come to trade.

“Funds can, but infrequently do, execute other forms of FX hedging, such as purchasing vanilla options: here, for a premium, they purchase the right but not the obligation to buy or sell a known amount of currency at a known rate on a known date. Alternatively, they can look at other more structured FX hedging solutions.

“Interest rate hedging can also take many forms: it could be a swap, a cap, or any other instrument. The rationale for selecting one hedging instrument over the other depends on the fund’s objectives and attitude to risk – there is no such thing as a typical hedge here.

“Inflation, while the topic du jour, is not often hedged outside of certain sectors. Those that typically would consider inflation are infrastructure funds, where there are long-term investments in which asset income is linked to inflation.”

To what extent does the strategy depend on the underlying investments or fund type?

“The timeline, certainty of the fund requirement, attitude to risk, and sometimes the size of the currency requirement all have a part to play in determining each fund’s FX strategy: there is no one-size-fits-all strategy that will suit a particular fund.

“The same applies to interest rate hedging, although in some instances nowadays funds that sit on the board of their portfolio companies are introducing interest rate hedging at board discussions to ensure all risks are considered.”

How should funds distinguish between long-term and short-term approaches to hedging? Which are more appropriate for which fund type, and how can they help mitigate risk?

“There is no right or wrong answer here – it very much depends on the underlying assets and the fund’s disposal strategy.

“It comes down to the areas the fund is exposed to, whether they can or want to mitigate that risk or whether they can live with it.

“For example, while infrastructure funds consider inflation’s impact on their asset income, they are less likely to be worried about its impact on asset values given their long-term horizon. But a private equity fund that is coming to the end of its life in the next two or three years will need to think hard about how to hit its profit realisation targets, perhaps considering setting up continuation funds to sit on the assets for a while longer.

“There could also be a place for non-financial-product solutions. For instance, since energy prices are rising, some funds, depending on their mandate, may consider investing in renewable energy to mitigate against that risk.”

How should fund managers approach using hedges? What implications or other factors do they need to be aware of?

“FX and interest rate risk are not normally funds’ primary concerns when making acquisition or disposal decisions. However, large swings in unhedged FX or interest rates can significantly affect returns, deal timing – or both.

“For example, a GBP-denominated fund looking to make an EUR acquisition on the day the outcome of the Brexit referendum in the UK was known in June 2016 would have faced overnight about a 6% increase in the acquisition price if the euros were purchased in the spot market with no hedging in place. With hedging in place, the euro acquisition price would have been pre-set, removing a risk that was outside the fund’s control.

“Given the current volatility of the FX market it would make sense for funds to consider implementing an FX hedging strategy before completing foreign currency-denominated acquisitions or disposals.”