Many investment funds are currency hedged. This is where the foreign exchange risk is eliminated or “hedged” by derivatives in the investment portfolio. In the Solvency II framework, a fully currency hedged fund can reduce currency risk by up to 25% of the funds market value. However, because of market fluctuations these funds will not always be completely currency hedged. That’s why you should calculate currency risk on all underlying instruments when stress testing the fund content as part of the solvency capital requirement (SCR). Hedging instruments will offset the risk on other investments reducing overall currency risk. Note that the risk-mitigating effect of hedging instruments may also have a significant impact on counterparty risk.
What is a currency hedging instrument?
There are several types of derivatives that can be used to reduce currency risk. Often, they are contracts where a future foreign exchange rate is agreed upon in advance. This gives predictability and reduces exposure to adverse currency fluctuations.
The most common currency hedging instrument is perhaps the currency forward contract. This is simply an agreement between two parties to exchange a certain amount of a currency for another currency at a fixed exchange rate on a fixed future date. Simply put, it’s an pre-determined exchange of one currency for another at a future date. Which party to the agreement will get the best deal depends on the future exchange rate. However, but both parties can benefit from the predictability of the outcome.
Stress testing currency risk
When stress testing currency risk in the Solvency II SCR calculation, the basic principle is to see how an increase or reduction in the currency exchange rate (against the reporting currency) affects the value of your assets and liabilities.
Let’s say an insurance company, with EUR as the reporting currency, owns a USD noted stock through an investment fund worth EUR 1 million at the reporting date. A 25% decrease in the USD/EUR exchange rate would then reduce the value of the stock by EUR 250,000. However, if the fund includes a currency forward contract, this can offset the effect.
By owning shares in the fund, the company indirectly owns the following currency forward contract:
Bought amount: 1,000,000 EUR
Sold amount: 1,200,000 USD
Exchange rate at reporting date: 0.8500
Exchange rate reduction (25%): 0.6375
An exchange rate reduction of 25% would in this example mean that the company pays 1,200,000 USD, which is then worth 765,000 EUR (1,200,000 0.6375). In exchange the company recieves 1,000,000 EUR . The currency forward contract is therefore favorable for the company, giving a risk mitigating effect of 235,000 EUR and reducing the overall currency risk of the fund.
If the fund had exclusively contained USD shares worth 1 million EUR and the currency forward in our example, the total currency risk for the fund would have been 15,000 EUR, equivalent to 1,5% of the funds value. This illustrates the importance of including the currency forwards when stress testing fund content.
Stress testing currency risk in practice
It’s worth mentioning that in the Solvency II regulations, only currency risk and risk mitigating effects in the reporting currency which shall be calculated. A USD / GBP currency forward contract will neither reduce nor increase the currency risk if the reporting currency is EUR.
Performing a stress test with full fund look-through can be time consuming. Sufficiently detailed data for full fund look-through can also be difficult to obtain. For currency forwards you need both the sold and bought amount in the local currency to stress test correctly. In our experience this information is often not readily available and as a result one must either use approximations or report a higher currency risk than is actually the case.