Market conditions such as implied volatility and current forward points are also important in determining the relative cost of options and cost-benefit of forwards respectively.
Finally, managers should ensure that any hedge takes into account the terms of the underlying investment. Using short-dated options or short-dated forwards on long-dated assets will see, in the first instance, a fund paying multiple fees on renewal or, in the second, being exposed to repeated unknown liquidity events. That might or might not prove suitable for the fund’s circumstances, but this ought to be considered.
Of course, these are not the only solutions. One alternative is to use a “natural hedge”, which involves aligning the currencies of the liabilities with those of the assets. Another is to do nothing, and use the FX spot market to convert currencies when needed; however, that leaves all FX risk with the fund and could induce significant performance gaps.
IV. No Perfect Solution
Ultimately the choice of hedging product comes down in part to managing a fund’s scarce liquidity. As always, there is no perfect solution: while using bought options means paying away a premium, using forwards means no upfront cost but the possibility of incurring a risk down the road.
It is worth noting that funds in different parts of the world face different challenges, so what works for a specialty fund manager in Australia won’t necessarily work for one in the US or Europe.
Although every hedge carries a cost, not hedging can end up proving much more expensive.