USD Strength and FX Hedging Considerations for Fund Managers

As global markets continue their attempts to adjust to the policies of President Trump’s second term, there is a resounding sentiment of uncertainty and volatility. However, one consistent market theme that appears to have staying power is the strength of the USD compared to other global currencies. While Trump’s continued push for tariffs, moves towards deregulation, and implementation of other trade tactics have thrown global currencies – and at times the US dollar – into a tailspin, the USD has found consistent opportunities to bounce back. When it comes to fund managers that hedge FX risks related to global investments, a strong USD presents numerous opportunities and considerations.

Because the majority of private capital is raised in USD, many hedge managers hold long USD and short foreign currency positions related to existing hedges. They also have an ongoing need to execute new hedges to buy USD and sell foreign currencies to hedge the FX risk related to new non-USD investments. In order to effectively evaluate current hedge positions versus new hedge executions, fund managers must look through varied lenses and operate with unique thought processes. For example, for managers simultaneously thinking about opportunities related to mark-to-market gains on existing hedges and potential challenges of buying USD through new hedges at historically high levels, they must operate with prudent decision making, taking on a holistic view of fund structure and investment goals, the underlying investments being hedged, and derivatives market dynamics. In today’s current market environment, factors such as mark-to-market gain accelerations and hedging transaction costs, the risks and benefits of executing a new hedge, potential liquidity needs related to hedging, and available liquidity through the lifecycle stages of investment funds must be evaluated closely to ensure hedging strategies continue to mitigate risk without unintended consequences.

The risk of accelerated gains

Fund managers that hold long USD through their hedges may have sizeable mark-to-market (MTM) gains that they wish to accelerate and realize today. While this strategy provides immediate access to cash that can be used for distributions to investors, debt repayment, or other activities that may be accretive to overall investment returns, managers must be aware of the discount factor that is applied to the future gains. In addition to simple present value calculations, managers also may risk accruing funding charges that become applicable when looking to accelerate gains early. Additionally, if the intention is to re-strike the hedge, new hedges will be placed at worse rates, incur new execution charges, and may create additional collateral posting and liquidity risks. To avoid these acceleration pitfalls, fund managers should consider the discount rate applied to the hedge gains as compared to the expected rate of return on the investment or fund. They can then determine if a gain acceleration is truly accretive to returns.

To hedge or not to hedge?

Due to ongoing USD strength, fund managers may find that now is a less-than-ideal time to initiate a new hedge where they are buying USD and selling a foreign currency. In this instance – while many managers take a programmatic approach to hedging and do not try to time the market – current conditions suggest that a more measured approach when entering into new trades may be warranted. Managers ought to consider a dollar cost averaging approach, where they layer in new hedges over time.  Additionally, there is the possibility that hedge providers expose themselves to increased credit exposure, as X-Value Adjustment (XVA) charges and execution spreads for new trades in the current market could be elevated due to heightened volatility and a reasonable likelihood of USD reverting to weaker levels over a period of time. Managers must carefully weigh the risks and benefits of initiating new hedges in a time of volatility.

The lifecycle of funds and liquidity

As new hedges are executed at strong USD levels, there is the potential for significant mark-to-market losses if FX markets revert to more historically normal levels. This is particularly the case for long-dated hedges. Ahead of trade execution, fund managers must ensure they are operating with a full understanding of the collateral terms in trading documents and are able to quantify the potential liquidity needs required for hedges as compared to available fund liquidity. Managers must also consider the lifecycle of any given fund. For a fund that’s in the later stage of its lifecycle, there may be liquidity constraints that should be considered to determine the ultimate hedge structure and whether hedging is an appropriate strategy for that fund.

A hedging strategy for success

There’s no question that fund managers are operating in an unsteady and tumultuous trading environment. With ongoing geopolitical tensions coupled with sweeping changes to the financial ecosystem by the Trump administration, having a clear and lucrative hedging strategy is vital. To ensure success, managers must consider various elements, including the risks and benefits of accelerated gain strategies, the value in executing new hedges, liquidity needs, and the availability of liquidity at various lifecycles of a fund. Managers that operate with a measured hedging strategy that can pivot based on specific fund types, market conditions, and other special circumstances will find themselves on a path toward long-term hedging success.

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Brett Morrell is Head of Risk Solutions at Derivative Path

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The views expressed in this article are those of the author and do not necessarily reflect the views of AlphaWeek or its publisher, The Sortino Group