We highlight some of the costs associated with FX execution and hedging that fund managers should be aware of and rank them in order of transparency.
Why do asset managers and corporates need to manage currency risk?
4 April 2022
The foreign exchange (FX) market is the largest and most liquid in the world – daily turnover reached $6.6 trillion in 2019.
Trading currencies means dealing with prices that are constantly moving up and down, often almost instantaneously in response to news from the financial markets, with the exchange rate of a given currency pair changing every half-second. This volatility and the unpredictable nature of the currency market has the potential to erode profit margins or investment returns if FX risk isn’t managed effectively.
FX risk is an inevitable by-product of doing business internationally, but by implementing FX hedging market participants can mitigate the risks involved using a variety of different currency products.
It is important to note that hedging practices are typically not designed to generate profits but, rather, to protect the bottom line or returns from investments.
The cost of ineffective hedging to corporates
A weakening domestic currency will typically increase the cost of importing. It can also make investing overseas more expensive, and the cost of servicing foreign currency debts will rise, too.
Conversely, when a domestic currency strengthens, exports become less competitive. Yet the cost of foreign imports will also normally decrease, giving importers a competitive advantage over firms that source goods locally.
According to research from HSBC, over 57% of CFOs, rising to 77% in EMEA, say they suffered lower earnings in the past two years due to significant unhedged FX risk.
The most recent Kyriba Currency Impact report found that the companies in North America and Europe reported $2.13 billion in negative currency impacts in Q3 2021.
The cost of ineffective hedging to asset managers
For asset managers, any assets held in foreign currency might change in value relative to their base currency. So even if their asset is performing well in its domestic market, if the currency of its domestic market drops, so too will the value of their asset. This undermines the value creation efforts of the investment manager and can negatively impact risk/reward ratio.
Furthermore, management fees may need to be exchanged to pay for overseas costs, such as international offices, so if the rate moves these costs might go up.
Importance of effective hedging in 2022
With economic changes, such as further interest rate rises on the horizon and recent geo-political tensions, we feel it is imperative that CFOs prioritise FX risk management to protect their firm’s bottom line or investment returns.
Against this backdrop we believe it is more important than ever that those trading in FXgain a transparent view of their execution setup, streamline their operational workflows and implement hedging strategies in order to carefully manage their currency exposures in the year ahead.