Short-dated foreign exchange (FX) forwards can be used to help minimize the FX rate uncertainty that arises between the time a global fund investment is contracted and the time the deal is funded.
The situation
US-based global fund (“Fund”), has raised US dollar (USD) capital and submits a bid for an overseas asset priced in euros (EUR). The bid is accepted and will be funded three to four weeks later. Simultaneously with the acceptance of the bid, the Fund may look to make a capital call for the USDs needed or instead opt to draw down from the capital call borrowing facility closer to the funding date. Either way, the amount of USDs needed will change between the bid acceptance date and the date the transaction is funded.
If the EUR appreciates, more USDs will be needed as the price is fixed in EUR. As a result, the Fund would need to call for more USD capital to close the transaction. This is an undesirable situation, as investors will have paid more for the asset than originally negotiated, eating into internal rate of return (IRR) and other investment performance metrics.
On the other hand, if the EUR depreciates and a capital was made on the bid acceptance date, capital will need to be returned, as fewer USDs will be needed for the acquisition. Economics aside, giving capital back presents and administrative and operational burden which many times renders the windfall more trouble than it’s worth.
Why hedge?
According to the long-term average price for an at-the-money option in the EUR / USD exchange rate1, we can assign a 1 in 10 chance that the EUR may move more than 5.2 percent in either direction over a 4-week period2.
Solution
An FX forward is a contractual obligation to exchange one currency for another at a pre-determined fixed rate and specific date in the future.
The Fund agrees to pay €50.0M to acquire an asset from a European seller, which translates to $57.5M according to the spot rate on the day the bid is accepted. Funds will be remitted in 3 to 4 weeks.
- EUR / USD spot reference: 1.1500
- Direction: Buy EUR / Sell USD
- Notional: €50.0M
- Contract rate: 1.1530
- USD equivalent: $57.65M
- Tenor: 4 weeks
Scenario analysis
The total USDs needed to close an overseas purchase can change materially over a 4-week period, from bid acceptance to deal funding. According to an objective probabilistic framework, there is a 10 percent chance that on a €50.0M price tag, the price can change by more than $3.0M in either direction. However, regardless of where the EUR / USD exchange rate is trading on the expiration date, according to the terms of the forward contract, the Fund will be selling $57.65M in exchange for €50.0M to make the investment.
Additional considerations
- A forward contract represents an obligation to buy or sell currency at a predetermined price. Should the deal fail to materialize, the Fund would need to cash-settle the forward hedge to fulfill the obligation, resulting in a gain or loss depending on spot movements during the hedge period
- In the event the deal were to close earlier than expected, forwards may be unwound early without penalty. As a result of the early unwind, the Fund would not be exposed to potential losses from movements in spot rates since trade inception, as the position is hedged. However, movements in the forward curve, which are less material over short horizons, may introduce residual gains or losses
- A delay in the expected deal close date can be handled by rolling the forward for an additional week, month, etc. as required. A “roll” is a standard FX contract, which requires a cash settlement
- An FX credit line or collateral posting is required to execute forwards. These are small for short-dated tenors
If you’d like to discuss your specific situation or for information regarding SVB’s tailored FX risk management services, reach out to your SVB FX contact or send an email to GroupFXRiskAdvisory@svb.com.
Read our other FX Risk Advisory papers.
1 Assumes an average implied volatility, IV, for the EUR/USD exchange rate of 11.5%.
2 Projected loss determined by IVT x SQRT(T) x Z(.90), IV is implied volatility, is years, and Z is from standard normal such that P(Z<z).
The views expressed in this article are solely those of the author and do not necessarily reflect the views of SVB Financial Group, Silicon Valley Bank, or any of its affiliates. This material, including without limitation to the statistical information herein, is provided for informational purposes only. The material is based in part on information from third-party sources that we believe to be reliable but which has not been independently verified by us, and, as such, we do not represent the information is accurate or complete. The information should not be viewed as tax, accounting, investment, legal or other advice, nor is it to be relied on in making an investment or other decision. You should obtain relevant and specific professional advice before making any investment decision. Nothing relating to the material should be construed as a solicitation, offer or recommendation to acquire or dispose of any investment, or to engage in any other transaction.
Foreign exchange transactions can be highly risky, and losses may occur in short periods of time if there is an adverse movement of exchange rates. Exchange rates can be highly volatile and are impacted by numerous economic, political and social factors as well as supply and demand and governmental intervention, control and adjustments. Investments in financial instruments carry significant risk, including the possible loss of the principal amount invested. Before entering any foreign exchange transaction, you should obtain advice from your own tax, financial, legal, accounting and other advisors and only make investment decisions on the basis of your own objectives, experience and resources.
All non-SVB named companies listed throughout this document, as represented with the various statistical, thoughts, analysis and insights shared in this document, are independent third parties and are not affiliated with SVB Financial Group.
The views expressed in this article are solely those of the author and do not necessarily reflect the views of SVB Financial Group, Silicon Valley Bank, or any of its affiliates.
This material, including without limitation to the statistical information herein, is provided for informational purposes only. The material is based in part on information from third-party sources that we believe to be reliable but which has not been independently verified by us, and, as such, we do not represent the information is accurate or complete. The information should not be viewed as tax, accounting, investment, legal or other advice, nor is it to be relied on in making an investment or other decision. You should obtain relevant and specific professional advice before making any investment decision. Nothing relating to the material should be construed as a solicitation, offer or recommendation to acquire or dispose of any investment, or to engage in any other transaction.
Foreign exchange transactions can be highly risky, and losses may occur in short periods of time if there is an adverse movement of exchange rates. Exchange rates can be highly volatile and are impacted by numerous economic, political and social factors as well as supply and demand and governmental intervention, control and adjustments. Investments in financial instruments carry significant risk, including the possible loss of the principal amount invested. Before entering any foreign exchange transaction, you should obtain advice from your own tax, financial, legal, accounting and other advisors and only make investment decisions on the basis of your own objectives, experience and resources.
All non-SVB named companies listed throughout this document, as represented with the various statistical, thoughts, analysis and insights shared in this document, are independent third parties and are not affiliated with SVB Financial Group.