Hedging strategies are always a balancing act – should the asset devalue, the hedge appreciates, while if the asset gains value, as has been seen recently in the robust performance of emerging market currencies compared with the anemic dollar, the hedge incurs a cost.
Despite the hedging strategies providing the desired protection, we have noticed that in volatile times, the challenge for GPs is how to approach the funding of hedges, especially those deep out-of-the-money (OTM), in light of high volatile markets and underlying assets with long term investment horizons.
The risk and work involved in hedge management is directly tied to the strategies in question, as well as the processes within the fund. However, when it comes to settling the cost of hedges on MTM (mark-to-Market) settlements, we see many firms still prioritizing other "deal related" obligations, with hedging being the last one to be paid.
This approach limits the alternatives available for firms to manage their currency risk, especially when relying on unlimited downside potential strategies. Here we explore how GPs can use an integrated approach to hedging strategy to minimize liquidity risk from hedging and meet their obligations without impacting their cash flow.
Understanding MTMs
Mark-to-Market, commonly abbreviated as MTM, represents a critical financial principle that often dictates the ebbs and flows of the financial world. At its core, MTM is the process of valuing assets and liabilities based on their current or "market" prices.
When it comes to hedging through forwards, MTMs are effectively the point where the hedging bill comes due, where GPs must settle the balance between the appreciation or depreciation of the asset in question and their original price. In recent months, where the USD has struggled and emerging markets have surged, these differentials can lead to significant adjustments. Effectively, funds must suddenly find additional liquidity to settle obligations that may be far beyond what was planned for, if planned at all.
Managing MTM risk in a volatile market
Hedging is, by its nature, built around uncertainty. In guarding against changes in currency prices, one must recognise that things can move beyond predictions. Given the windows in which hedges can run, many firms focus on the short term costs – those of financing the hedge – rather than the long term costs of the eventual MTM settlement.
This brings embedded risk and opens firms up to major liquidity challenges – but the fault often lies with the systems in place, rather than the individuals making choices.
Forwards versus Options
Hedging is a complex task, with a wide variety of variables and possible outcomes. Without the ability to accurately forecast or compare the potential costs of various alternatives, most firms will often default to the choice with the lowest upfront cost.
Forwards: Usually have no initial premium, as long as the counterpart doesn’t require an initial margin, but market movements can trigger margin calls, demanding additional collateral or settlements.
Options: Long options involve an upfront premium for the right (not the obligation) to transact, offering limited downside potential of MTM (i.e upside potential exposure) but typically at a higher initial cost. Combination of short and long options can help reduce the usual liquidity requirements of forward hedges.
Forwards are the simpler route for most hedges, with less analysis required, no upfront payments and the potential to realize a gain if the market moves in your favor. However, the costs, should the market go against you, are unlimited.
Historically, in a highly liquid market, high MTM costs could be managed with freely available credit but the volumes available to firms have shrunk as interest rates and volatility have increased. And given the tendency of firms to delay the allocation of liquidity until the last moment, GPs can find themselves forced to take on credit at higher rates, at a cost to their margins.
Proactive planning and financing can essentially eliminate such risks, but this requires the right visibility, advice and controls.
Building a proactive liquidity strategy
In our work with leading funds, we focus on giving GPs the tools to make the right decisions at the right time to manage liquidity in both the short and long term.
When considering each hedging strategy, we consider:
Performance: Assessing the protective nature of the strategy and its potential to generate an upsell.
Liquidity Risk: Evaluating potential repercussions if market conditions turn unfavorable.
Cost of Hedging Analysis: Determining the impact on the underlying financial performance of the investment or its return.
By taking a holistic view of the merits of each strategy, we help GPs ensure that the liquidity requirements are planned ahead at each stage to minimize risk through:
Cash flow analysis: Working with a holistic view of upcoming hedging obligations to match liquidity events with expiry dates for hedges, deploying freed capital to manage costs without the need for credit tools.
Credit resources: We work with a range of leading credit providers to source liquidity according to robust cost analyses at competitive rates.
Planning and methodology: We employ statistically-based analysis to ensure the right decisions are made based on the performance of each strategy. Instead of solely relying on payout diagrams, we analyze market scenarios to discern the value of specific hedges and pre-allocate capital to MTM cash flow disruptions.
As conditions continue to evolve and credit remains tight, the onus is on GPs to ensure that they’re protected against market fluctuations and MTM liquidity risk. To find out how you can protect yourself, get in touch.