Why rising rates could adversely affect your FX hedging

by Richard Class

FX hedging

Challenging markets cause havoc for FX hedging

Achieving best execution and minimising timing mismatches are necessary features of implementing an effective hedging strategy. We examine why this has become more challenging as 2022 has evolved and how your company can improve its hedging outcomes.

2022 has been a difficult year for markets as the ongoing effects of Covid have been compounded by the Russian invasion of Ukraine. This has led to a dramatic rise in energy prices and a significant increase in inflation. It can be argued that developed market central banks were slow to recognise that inflation was persistent and not merely transient. Their delayed response in tightening monetary policy may require interest rates to be increased to a much higher level than if policy had been tightened more quickly.

Higher interest rates and more volatility

The impact of higher interest rates and more volatile market conditions may cause market spreads to widen on both forward FX and over-the-counter interest rate derivatives. As we approach the last quarter of 2022, year-end liquidity pressures (known in market parlance as “the turn”), may also cause pricing to deteriorate. Furthermore, in a scenario where the macro backdrop worsens and risk appetite falls, investors may seek to hold more liquidity in US dollars, which is still seen as the world’s reserve currency. If this happens, anyone needing to buy US dollars versus other currencies via the forward FX markets will see hedging costs rise as demand for US dollars pushes FX forward points higher (known in the markets as “negative FX basis”).

Over the last decade, both the turn effect and negative basis have increased hedging costs by more than 100bps on several occasions. We believe that an understanding of these factors and a proactive and timely approach to hedging can ameliorate these risks.

More volatile markets may also mean that the impact of any unintentional timing mismatches between underlying positions and your hedges could be significant.  For example, three-month Euribor rose 50bps during August alone. In the last decade, any timing mismatches between when you pay or receive floating rates would have had a negligible effect on performance, as Euribor rates have been almost constant. However, if you received three-month Euribor at the beginning of August and paid it at the beginning of September, that one month timing mismatch would have cost you 12.5bps.

Optimising your hedging strategy

Optimising your hedging strategy is more than merely about reducing costs. The direct consequence of improving the execution and timing of your hedges is that you boost your alpha, as the frictional and often hidden costs of implementing your investment strategy decrease. The result of optimisation would be enhanced returns for your investors and outperformance versus your peers, all whilst reducing operational risks.

Where to turn for unbiased help

What solutions can OptimX offer to these problems?  OptimX has extensive sell- and buy- side market experience. We are independent and unbiased. We understand how markets work and can help you achieve lower costs and to consider whether there are better or more efficient ways to hedge your market risks, whilst you retain control. OptimX works in partnership with our clients, aligning interests and we are rewarded by results.  Is it time you reviewed your firm’s hedging strategies?  Contact OptimX for a no-obligation consultation to review your options.