Today’s topic deals with an unavoidable source of friction in the FX hedging markets: Execution Timing Lags. The distance between valuation and execution in currency hedging can have an impact in the mitigation of spot movements.
We recall that currency hedging aims at removing the effects of spot movements from a financial position trading in a foreign currency. For the sake of clarity, we stick to exposures derived from financial assets, although our conclusions generalise to other types of exposures.
Currency risk is created at valuation time. The fund manager takes the market value of the assets in foreign currency and converts it to base currency using the FX spot fixing value. Then, it must inform the currency manager of the new exposure after valuation has taken place.
We define Execution Timing Lag (ETL) as the impact of executing hedging trades after valuation time, and therefore, at a different price than the FX fixing price used to convert the assets to base currency.
The currency manager executes hedging based on the latest information available. By the time the latest exposure value has arrived, the price has potentially moved away from the valuation point.
Additionally, within the intricacies of currency hedging, some trades are scheduled independently from information arrival, e.g. rollovers. Rollover trades come in pairs (near and far leg), and their utility is to extend currency hedging beyond the maturity date of the current hedges in place.
The near leg of the rollover closes the current hedging position (creating a cashflow between the ccy. manager and the fund manager), and the far leg extends it to the next maturity date. There are two types of far legs, as depicted in the following table.
|Near leg||–||–||Sum of open trades (opposite sign)|
|Far leg||Matched Swap||MS||Near leg (opposite sign)|
|Mismatched Swap||MMS||Value s.t. HR = THR|
In the following lines, we will discuss the following questions:
- How can Execution Timing Lags be minimised? Can they be cancelled?
- What is the best time to execute scheduled trades (such as rollovers)?
Execution Timing Lag Minimization
ETL can be minimized, but never truly cancelled. The closest one can get to minimize it is executing hedging trades at valuation time. But even if one hedged the exposure as it is valued, the ETL could not be cancelled.
The reason behind is the FX fixing rate calculation procedure. These rates are the result of an aggregation of prices occurring in the market in real-time. This means that the fixing rate at 16h is actually determined some minutes later.
So, even if you hedged the exposure as it is valued, you would trade at a different price from the final fixing aggregation (although potentially closer to it than if you wait several hours). Therefore, the ETL measures not only the lag in time from valuation, but also any possible fluctuations due to the fixing calculation procedure.
Scheduled Trades: Best Timing
Now that the origin and the effects contained in the ETL have been clarified, we are going to analyze it in a real-case scenario. We are going to consider two modalities for scheduled rollover trades, executed as mismatched-swaps (MMS).
- Modality Split: executes the rollover (R) in the morning for the last known exposure value at valuation time (when the new exposure is being calculated). In the afternoon, when the new valuation is received, if HR bands are breached a Hedge Adj. (H) is executed.
- Modality Combined: executes the rollover (R) in the afternoon when the latest valuation is received.
Modality Combined never executes near valuation time. It always ends the day at Target, since it trades with the latest information.
Modality Split executes the first trade close to valuation price, and if the new valuation is within bands, ends the day away from Target but at a valid hedge ratio value.
If the new information breaches the bands, the afternoon hedge adj. trade will be executed, and Modality Split will end the day at Target. The execution price for that day is a weighted average of the rollover at noon and the hedge adj. in the evening:
The notional of the rollover is potentially larger than the one from the hedge adj., and hence the price is closer to the valuation price, or at least more diversified. An exception to this fact is when the new valuation contains a massive inflow or outflow, and hence the notional of the hedge adjustment is larger than R.
In terms of Execution Timing Lag, modality Split will lead to a smaller impact, because it is more likely to execute near the valuation price than modality Combined, which never executes near valuation price.
The only drawback modality Split has is that it will potentially lead to a larger Hedge Ratio Filter Impact, since it only ends the day at Target when the bands are breached.
Taking into account that passive hedging always includes acceptable hedge ratio bands, being within them is an acceptable scenario.
The scheduled trade must be executed anyway, so why not minimise the ETL on its way?
If your hedging strategy contains scheduled trades, you are better off executing them shortly after valuation time, having received or not the most recent valuation point.
|Execution Timing Lag|||||Hedge Ratio Filter|
Thanks for reading, and see you around!