Cross currency basics 5 – Portfolio versus individual deal hedging

Mar 3

This is the fifth instalment of my series on cross-currency swaps. Previous articles have covered the basics, looked at some pricing aspects and the revaluation challenges brought about by changing conventions and some examples of how cross-currency swaps are priced in practice.

In this blog I will look at how the portfolio and individual deal hedging works and some of the challenges for end-users.

Firstly a few definitions:

1) Portfolio hedging

Some firms, such as investment funds, have a number of portfolio managers and currencies where returns have to be converted back to the domestic currency. Other firms, such as corporates, may have revenue and costs in different currencies which likewise must be managed and/or converted to their domestic currency.

Some of these firms use a portfolio hedging approach where they broadly manage the risks and cashflows with a few cross-currency swaps and separately manage the cashflow mismatches with short-term products such as forward FX.

The following diagram shows this approach for EUR and JPY exposures swapped with two cross-currency swaps to USD.

1) Individual deal hedging

Another way to manage the currency exposures is to exactly match each risk with a specific cross-currency swap which converts each cashflow into the domestic currency. The aim is to minimise the mismatches and remove any currency risk from cashflows.

The following diagram shows this approach for the same EUR and JPY exposures but individually swapped with six cross-currency swaps to USD.

Portfolio and individual deal hedging each has benefits and challenges which need to be carefully considered before trading and also during the lifetime of the trade.

Portfolio hedging

This approach uses an overlay technique to provide a broadly-based hedge rather than look at individual risks. It is often used by larger firms who consolidate their currency hedging into a single desk. For example:

Large investment firms often use a mix of external and internal fund managers to spread risk and returns across currencies and management styles. This can result in many currency exposures which need to be converted to the domestic currency.
Large corporates can have a variety of debt and revenue exposures across currencies and maturities. This leads to a complex exposure where they need to balance the assets and liabilities per currency and ultimately back to the domestic currency

In these examples, the number of exposures and currencies can make a portfolio approach more efficient and easier to manage both operationally and for risk.

Benefits and challenges of portfolio hedging

Benefits include:

The number of trades is reduced, often resulting in more tractable system and process management.
The number of settlements is also reduced which can save on operational costs and reconciliation processes.

Challenges include:

The exposures are only approximately hedged which can lead to cashflow mismatches and tracking differences.
Accounting treatment can be complex (hedge effectiveness tests).
Short-term cashflow differences need to be managed with other products such as forward FX which can lead to additional costs and complexities (more on this in a later blog).
The maturity of the cross-currency swaps may not match the underlying risks leading to the potential for over or under hedging.
Allocation of the costs and benefits to each portfolio can be challenging.

Individual deal hedging

This approach exactly matches each exposure with a cross-currency swap. Many firms, especially ones with limited exposures to other currencies adopt this technique. For example:

Investment firms with only a few offshore investments tied to specific assets with known returns and maturities.
Corporates with offshore debt issues and domestic assets that the funding is directly supporting.

Individual deal hedging is attractive to many firms but, like portfolio hedging, has benefits and challenges.

Benefits and challenges of individual deal hedging

Benefits include:

The cross-currency trades will match the underlying exposure and the cashflows will net in the non-domestic currency thereby reducing the need for additional cash management.
Accounting can be simplified with the one-to-one match.

Challenges include:

The number of trades could be significant leading to additional system and process requirements to manage the settlements and reporting requirements.
This is not scalable – it is only effective for a relatively small number of exposures.

Which approach is better?

There is no answer for this question: it all depends on your circumstances. However, there are a few basic inputs to any decision:

How many exposures do I have or are likely to have? A small number may mean the individual deal rather than the portfolio approach as a more efficient and appropriate solution.
How sophisticated is my trading capacity? The portfolio approach assumes a high level of trade management and ability to successfully manage many settlement mismatches in various currencies.
How will my systems and processes manage? A large number of trades, which may result from the individual deal approach, may require advanced systems and processes. The potentially smaller number of trades in the portfolio approach can simplify the swaps but may complicate the forward FX management.
Do I have specific accounting and reporting requirements? This is definitely a consideration as it may favour one approach over the other.
Could I use both approaches? Yes, this is possible and may actually suit many firms with segregated businesses and/or exposures. For example, a single debt issue may be individually hedged but revenues may use the portfolio technique to better advantage.

As I said above, it all depends.

Summary

There is no simple way to approach the complex task of swapping non-domestic currencies to the domestic currency. Every firm with an exposure will have to manage the cashflows in some way and this is often done with cross-currency swaps.

It is vital to assess your operational and risk management capacity to make a decision. A recent blog by Ross Beaney about the need for clear frameworks is very applicable here. Without an honest assessment of your capabilities and an agreed framework for any actions, there is a real probability of a sub-optimal (i.e., disastrous) outcome.

A thorough analysis of your capabilities and exposures is a great start, or a great review of a current process. We have done this many times and really recommend a structured approach to minimise the risk of operational mayhem and/or pricing errors.

John Feeney