How a thoughtful FX strategy can give Fund Managers a competitive edge

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 p.4 p.5 p.6 p.7 p.8-10 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% 14.00% Volatility against USD 12.00% 10.00% 8.00% 6.00% 4.00% 2.00% 0.00% One month Three months Six months One year EUR 1.54% 5.98% 10.40% 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%. Unhedged, 10% asset appreciation Original Asset Cost New Asset Value EUR 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. 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 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. 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: Hedged, 10% asset appreciation Original Asset Cost New Asset Value EUR Rate USD EUR Rate USD Investment/return 1,000,000 1.2626 $1,262,600 1,100,000 $1,383,850 Hedged 1,000,000 1.2626 $1,262,600 Unhedged 100,000 1.2125 $121,250 Absolute gain/loss $121,250 % Gain/loss 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. As a financial institution, AFEX is required by law to conduct business in a manner consistent with the best interests of its clients and in accordance with Federal and State regulations governing foreign exchange and money transmission activities. We are dedicated to operating in a safe and sound manner, with the highest legal and ethical 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. 2015 Associated Foreign Exchange, Inc. All rights reserved. Associated Foreign Exchange, Inc. ( AFEX ), located at 21045 Califa Street, Woodland Hills, CA 91367, is a Money Transmitter licensed and regulated by multiple regulatory agencies including the California Department of Business Oversight, the New York State Department of Financial Services, the Illinois Division of Financial Institutions, and the Texas Department of Banking. For more information, visit https://www.afex.com/unitedstates. This brochure has been prepared solely for informational purposes and does not in any way create any binding obligations on any party. Relations between you and AFEX shall be governed by applicable terms and conditions. No representations, warranties or conditions of any kind, express or implied, are made in this brochure.

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