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Risk Management

What is the difference between Passive Hedging and Active Hedging?

aporras

27/07/2022

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To hedge or not to hedge is a dilemma that needs to be faced whenever currency risk comes into our lives, stemming from having spread our investments or business in foreign assets. There is no global correct answer, as it will depend on the particular situation you face to: What is the risk currency? USD? EUR? ZAR? What do you expect from this risk? What are the hedging costs? etc.

Every problem requires its own study and currency risk strategy. 

Passive Hedging

When we are sure that we want to hedge our exposure, we speak of Passive Hedging. It consists of systematically holding the opposite currency position to offset the unwanted movements of the exposure. Hedging is the resolution to avoid possible losses in exchange for giving up possible gains.

It is normally carried out by means of forward contracts. A forward contract consists of agreeing on a future price to execute a future transaction. This price depends on the Interest Rates Differential between the two currencies involved. It can be positive or negative, so it may mean a cost or an extra return directly arising from the hedging decision. What’s more, we need to consider the transaction costs, always negative, as part of the trades execution.

Of course, the aforementioned operation must be well implemented. It may seem easy to execute a forward contract, but there will be various details to pay attention to: 

  • The term of the contracts will have to be fixed.
  • The forward will expire and will have to be renewed or not, or only part of it. 
  • It will be necessary to ensure that the agreed prices are indeed prices in line with the market.
  • It is especially important to monitor changes in risk exposure to adapt the hedge accordingly. If the exposure changes every day, for example, the application of a rigorous passive hedge could become a mess. 
  • In this previous case, it would also be possible to implement certain filters to avoid trading for a negligible amount.

A poor understanding of the Forex Market or errors in the process could lead to losses caused by a risk that was supposed to be controlled. 

As proper Passive Hedging is not as straightforward as it may sound, it is common to outsource this type of service to a specialist and reserve efforts to work on your core business. Getting rid of this management will obviously entail a service cost. 

Whether on your own or outsourced to a Currency Manager, once you decide to implement a passive hedging strategy, you can forget about any currency risk worries, for better or worse. Well, not completely.

However, there are pros and cons to everything, and there is also a dark side to passive hedging that could force you to make the decision to go without hedging. Let’s go over them:

Hedging is perfect…  

  1. … when you want to avoid the additional volatility derived from the currency 
  2. … when you don’t worry about missing potential gains from the currency 
  3. … when you can afford hedging costs, possibly swap points and certainly fees.  

Conversely, you should not hedge… 

  1. … when you actually want to take on the currency risk, because you believe your risk currency will appreciate. Although the level of uncertainty in this regard is always high, it may not be so high at times.
  2. … when there is a strong negative correlation between the currency and the investment. As we discussed here, the relationship between the currency and the asset should be so strong that this argument becomes quite weak.
  3. … when you accept currency risk, because hedging is so expensive that it could easily fail to compensate for the risk taken. This is sometimes the case with Emerging Currencies, where illiquidity and large interest rates differentials could be a drag on performance. 
  4. … when you have to accept currency risk, because hedging cash flows produce a problem you can’t deal with. In this post, we illustrated a detailed explanation of this issue.

Active Hedging

The above list shows several situations that may change over time. Therefore, you could decide either to hedge or not depending on the currency landscape. Whenever there is a changeable decision between hedging or not hedging, you are applying Active Hedging

To hedge or not to hedge: Possible strategies
To hedge or not to hedge: Possible strategies

Active Hedging seeks to optimize currency risk. Its objective is twofold: It will pay attention to loss prevention, but it will also try to generate some returns. As no one has a crystal ball, a partial result can be expected both in limiting losses and in taking advantage of gains.

While Passive Hedging is usually entrusted to a specialist Currency Manager because of the work involved, Active Hedging is almost always outsourced because its implementation is more complex. The fees will be higher, since, in addition to the operational service, it will normally include hedging decisions, which are the key point in this type of strategy. Currency Managers offer dynamic solutions that systematically adjust the Hedged Ratio to the market conditions. This is proved to be beneficial especially in periods when the risk currency rises or falls significantly.

To hedge or not to hedge: Pros and Cons
To hedge or not to hedge: Pros and Cons

The Unhedged result will be derived entirely from spot movements, while the impact of Passive Hedging will be that of swap points, which we will add fees on top. The result of Active Hedging will be a mix of spot, swap points and fees. The contribution of each of them will depend on the hedge ratio decided at any given time. The more unhedged you are when the spot moves up, the higher the return. Similarly, the more hedged you are during bearish moments, the higher your return will be. 

The Active outcome implies a great uncertainty. It is highly unlikely that two Active Hedging strategies will obtain the same result for the same time period. The hedging strategy will be absolutely key in determining a good outcome.

To hedge or not to hedge: Results
To hedge or not to hedge: Results

To conclude, we show the following scheme that summarizes the factors that impact on the three possibilities. It is necessary to note that once you choose to hedge, either actively or passively, factors other than the spot will enter the equation. Each strategy shifts the original currency risk to other risks, whose impact is presumably preferable

To hedge or not to hedge: Full picture of the factors involved
To hedge or not to hedge: Full picture of the factors involved

To sum up

While Passive Hedging consists of eliminating (almost) all the currency impact, Active Hedging aims to optimize it. Implementing an Active Hedging strategy means adapting the degree of hedging to each specific moment. It will be absolutely relevant that these decisions are correct to ensure a positive outcome. A successful active strategy could turn this preliminary unwanted currency risk into an extra return. 

Nevertheless, the arguments in favor of active currency hedging are not based on profitability alone. Investors may consider Active Hedging as an intermediate solution to try to improve cash flow management or in scenarios where hedging is prohibitively expensive.

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