For both fund managers and corporations, as access to funding remains challenging in this new era, and revenues are reduced due to the virtual shutdown of the economy, liquidity in the form of access to cash is critical for businesses to remain functional or in some cases, viable. One source of this precious liquidity is the mining of your hedge portfolio for positive mark-to-market that can be turned into cash.
This is done by ‘re-striking’ hedges to current market prices. As an example, let’s assume that 2 years ago you sold 100 million EURUSD forward for 5 years at a forward rate of 1.4000 to hedge your FX risk (remember when forward rates were that high?!). If you were to execute that now 3-year trade today, you would do so at a rate of 1.1250 (today’s spot rate of 1.0910 plus forward points of +.0340).
The mark-to-market of $27.5 mio (calculation: 100 mio * (1.4000 – 1.1250) = $27.5 mio) can be accessed through re-striking the hedge at today’s rate, and then net present valuing (NPV) the profit. On paper this is a great idea, and it may indeed be, but it must first be carefully considered.
Key considerations in the re-striking of hedges
- The first thing to consider is that not only are you as a company keen on finding sources of liquidity, but so are your counterparties. Not all banks have equal access to the Fed’s swap/lending facilities. Therefore, some banks are imposing very high discount factors in the calculation of the NPV of the profit. The NPV of the MtM is, after all, a loan made by the bank to you. Whereas in the past the typical discount factor applied in the calculation would be Libor+ circa 150-200 bps, we’re now seeing some banks charging Libor + 600-700 bps. That can have an impact on your profit in the hundreds of thousands of USD.
- A second consideration for those funds who regularly utilize Historical Rate Rollovers (HRR) in their hedging strategy in order to avoid cash settlement events at the rollover date, is that once you re-strike hedges, most banks will no longer allow you to use HRRs going forward.
- A third and critically important consideration is that once the economy restarts, there is a high probability that we will see a reversal of the USD strength that has been the theme since the onset of the crisis. What will the impact be on your liquidity if this happens?
As chart 1 shows, we’ve already seen a correction in the USD strength that reversed 40% of the gains since the lows in March. For a client selling currencies forward vs USD, this means that the MtM of your hedging portfolio has declined significantly in the past 2 weeks.
Chart 1: US Dollar Index (March 1 to present)
The image below shows the MtM of a fictional portfolio of hedges for a Fund (as shown on the Validus RiskView dashboard). As you can see by the chart, the MtM fluctuates over time as the spot and forward rates for the currencies hedged fluctuates. On March 23rd this MtM hit a maximum value of $88 mio. Imagine if the fund had taken all of this profit at that time through re-striking their hedges with the two banks on their panel, and NPV-ed them to realize cash gains.
Since March 23rd, the USD has sold off against most currencies, and the MtM of the hedges has declined from $88 mio to $30 mio, a change of $58 mio. Had the Fund realized all of the gains previously, they would now have a negative MtM of $58 mio, and might be hitting the credit thresholds available to them. This means they may have to post back some or all of the realized gains with the bank. This may mean calling back capital which they had only recently returned to investors, on top of having incurred high NPV costs.
For those with completely uncollateralized lines, it may mean that the next time they want to add a hedge their bank refuses to allow new trades, as they are unable to take on the additional credit risk on top of the already $58mio in negative MtM.
For corporations, some banks have been imposing very significant restrictions on requests for re-striking, as the banks are concerned over the long-term impact of the economic shutdown on come sectors. Anecdotally, one retailer was told by their sole bank, that if they re-strike their hedges, from then on they would be required to post margin for all new hedges, which would make future hedging virtually impossible for the corporation.
Conclusion: Whilst mining your hedge portfolio as a source of liquidity may be a very good idea, there are considerations to review before you do so. Validus can assist you in reviewing these considerations, and in discussions with your counterparties. As importantly, we can discuss ways to minimize these liquidity risks moving forward.