How to Handle Currency Risks in Offshore Funds

Currency risk is one of those problems that sits quietly in the background—right up until it dominates your returns. If you run or invest in offshore funds, you’re dealing with at least two currencies (often more). That can either diversify returns or introduce a layer of volatility and cost you didn’t sign up for. The good news: with a clear policy and disciplined execution, you can choose how much currency risk you want, what you’re willing to pay to manage it, and how to keep the operational headaches in check.

Why Currency Risk Matters in Offshore Funds

Currency can add or subtract several percentage points from performance in any given year. MSCI and other providers have shown that for USD-based investors in global equities, currency movements can account for roughly 25–35% of total volatility over long periods. Major pairs like EUR/USD, GBP/USD, and USD/JPY typically show annualized volatility around 8–12%. Emerging market currencies often run well above that.

Two layers of currency exposure often exist in offshore funds:

Portfolio currencies: the currencies of the underlying assets (e.g., Japanese equities in JPY).

Fund/share class currency: the currency in which the fund reports and investors subscribe (e.g., EUR share class of a Cayman or Luxembourg fund).

Your base currency as an investor might be different again. That creates a stack of exposures that can move in different directions. Example: a USD-based investor buys EUR share classes in a fund that owns Japanese equities—USD vs EUR and EUR vs JPY both matter, and they don’t always offset.

The economic stakes are real. A 10% equity gain can be largely wiped out by an 8% adverse FX move. Conversely, hedging decisions can add 2–5% a year in carry when interest differentials are in your favor. This isn’t an academic exercise; it’s a material driver of returns, volatility, and funding risk.

Mapping Your True Currency Exposure

Before touching a derivative, get an honest inventory of exposures. Most errors I’ve seen stem from hedging the wrong layer or forgetting something that appears “immaterial” until it isn’t.

Base currency: the currency in which you measure success (e.g., the investor’s reporting currency).

Fund base currency: often USD, EUR, GBP for offshore vehicles.

Share class currency: the currency investors subscribe/redeem in (hedged or unhedged classes).

Underlying asset currencies: where the portfolio risk actually lives.

Cash, income, and corporate actions: dividend currencies, coupon currencies, pending corporate action currencies.

Subscriptions/redemptions and unsettled trades: the “plumbing” that swings exposures day to day.

A clean exposure map ties all of this to a single base (usually the investor’s or fund’s). If I had to pick one “always do this” step, it’s look-through exposure reporting at least monthly, daily if flows are active.

A quick example

Investor base: USD

Fund base: EUR

Share class: EUR (hedged and unhedged available)

Portfolio: 60% Japanese equities (JPY), 40% European equities (EUR)

Unhedged EUR share class exposes a USD investor to:

EUR/USD via the share class and fund base currency

JPY/EUR via the JPY assets in a EUR fund

Net effect vs USD: combined EUR and JPY exposures, not just EUR/USD

Hedged EUR share class (EUR-hedged) removes much of the EUR vs portfolio currency volatility from the share class perspective, but the USD investor still owns EUR vs USD risk unless they hedge at their account level. The point: identify which layer you want to hedge—portfolio, share class, investor level—or you may hedge one layer and accidentally leave the bigger one exposed.

Exposure types to track

Strategic portfolio currency exposures (look-through by position).

Cash balances by currency.

Accrued income and expected dividends/coupons.

Subscriptions/redemptions and unsettled trades (e.g., T+2 equity, T+2 FX).

Derivative margin and collateral in various currencies.

Share class-level hedges (if applicable).

Hedging Objectives and Policy

Decide what you want the hedge to do. Lower volatility? Minimize tracking error to a hedged benchmark? Monetize carry? Protect funding ratios for a pension plan? Different goals lead to different hedge ratios, tenors, and instruments.

Key elements of a robust policy:

Scope: which currencies, layers (portfolio vs share class), and asset classes are eligible.

Target hedge ratios: e.g., 0%, 50%, or 100% for each currency/asset class; ranges are often better than point estimates.

Benchmarks: unhedged and hedged indices; or a custom currency index that matches exposures.

Tenor and roll strategy: 1-, 3-, 6-, or 12-month forwards; laddered approach; how you rebalance.

Limits: per-currency notional, counterparty exposure, leverage measures (particularly for UCITS).

Governance: approval matrix, exception processes, and how to act in stress events.

Reporting: performance attribution, hedge P&L, carry, slippage, and residual exposure.

Investor disclosures: share class hedging practices, costs, and expected residuals (important for UCITS/AIFs).

For equities, many institutions hold a 30–70% strategic hedge to moderate volatility without fully giving up potential diversification. For fixed income, currency volatility can swamp bond volatility; most global bond portfolios are largely or fully hedged to the base currency.

Choosing Hedging Instruments

There’s no one-size-fits-all tool. Choose based on liquidity, cost, operational fit, and regulatory constraints.

FX forwards and swaps

The workhorse. Liquid, customizable sizes and tenors. Pricing reflects interest rate differentials (carry) plus a spread and, in some cases, a cross-currency basis.

An FX swap is effectively a forward with a near-leg to exchange cash now and a far-leg to reverse later—useful for rolling and for cash management.

Non-deliverable forwards (NDFs)

Used when physical delivery is restricted (e.g., INR, CNY onshore, KRW).

Cash-settled in a hard currency (usually USD) at a published fixing.

Liquidity varies; settlement fixing risk and holiday calendars matter.

Options (puts, calls, collars)

Provide asymmetric protection with a premium cost; useful when drawdown protection matters or during known event risk.

Participation forwards and zero-cost collars can reduce upfront premium but limit upside.

Cross-currency swaps (CCS)

Best for hedging bond portfolios where you want to convert coupons and principal into base currency.

Can introduce basis and collateral considerations; longer maturities than typical forwards.

Share class hedging derivatives

Often executed at the share class level (especially in UCITS/SICAV umbrellas) to align share class currency with the investor’s chosen currency.

Requires robust tracking of share class NAV, flows, and strict controls to avoid over-hedging.

Cost mechanics and carry

FX forward pricing is driven primarily by the interest rate differential between the two currencies (plus any basis and spreads). Practically:

Hedging a lower-yielding currency back into a higher-yield base tends to earn positive carry.

Hedging a higher-yielding currency into a lower-yield base tends to cost carry.

Recent example ranges (illustrative, not quotes):

USD vs JPY: with USD rates several percentage points higher than JPY in 2023–2024, hedging JPY back to USD could earn around 3–5% annualized carry via forwards.

USD vs EUR: differentials closer, often 1–2% annualized carry.

EM NDFs: costs/spreads higher; carry can be positive or negative and more volatile.

Other cost components:

Dealer spreads and market impact (tight for G10 majors, wider for EM).

Cross-currency basis (periodically material; can be favorable or unfavorable).

Collateral and margin financing costs.

Carry is not “free yield.” It compensates for rate differentials and can be offset by spot moves. Over long cycles, DM currency returns tend to mean-revert, which is why many investors hedge to reduce volatility rather than to “earn carry.”

Building a Practical Hedging Program

Here’s a step-by-step approach I’ve used with offshore funds and institutional clients.

1) Define objectives and policy

Decide which currency risks are intentional and which are incidental.

Set strategic hedge ratios (by asset class and currency) and permissible ranges.

Select benchmarks and how you’ll report attribution.

2) Map exposures and data infrastructure

Look-through currency exposure by position, cash, and pipeline trades.

Align positions and FX exposures to a single base currency in your risk system.

Build a daily or weekly exposure feed (position, price, and FX rates synced).

3) Put legal and counterparty plumbing in place

ISDA/CSA agreements with 3–6 counterparties; diversify exposures.

Define eligible collateral (cash/non-cash), haircuts, and operational cut-off times.

Establish dealing limits and preferred execution protocols (RFQ, streaming, TCA).

4) Choose instruments and tenor strategy

Forwards for most equity currency hedging; CCS for bond portfolios with ongoing coupon flows.

For EM currencies, use NDFs and consider partial hedging.

Decide tenor: 1- or 3-months for active programs; 6–12 months for simplicity and lower churn; ladder to smooth timing risk.

5) Execute and allocate hedges

For portfolio-level hedges, size to the look-through exposure times the hedge ratio.

For share-class hedging, size to the share class NAV and flows; keep residual exposure within strict bands.

Document allocations so hedge P&L maps correctly to the right fund/share class.

6) Collateral and liquidity management

Estimate variation margin needs under stress. For a 10% FX move and 80% hedge, what’s your cash requirement?

Align collateral currency with your base to avoid compounding FX risk in margin calls.

7) Rebalance and roll

Rebalance on set dates (e.g., monthly) or when exposures drift beyond thresholds.

Roll forwards before expiry; stagger rolls across the month to reduce fix risk.

Incorporate subscriptions/redemptions and corporate actions to avoid over-hedging.

8) Measure, report, and review

Attribution: asset return, currency spot, and carry/roll components.

Track realized carry vs expected; TCA on FX execution; counterparty concentration.

Quarterly policy review; adjust hedge ratios if objectives or market conditions change.

Tenor strategy and rebalancing

Short tenors (1–3 months): tighter tracking, simpler rebalancing, more operational load, more transaction costs.

Longer tenors (6–12 months): fewer trades, less admin, potentially wider spreads and more mark-to-market swings.

Laddered approach: split the notional across several maturities to avoid single-day roll risk and to smooth P&L.

Rebalancing methods:

Threshold-based: rebalance when exposure or hedge ratio drifts beyond, say, ±5%.

Calendar-based: align with month-end NAV and benchmark rebalancing schedules.

Flow-aware: adjust hedge notional intraday for large subs/reds or corporate actions.

For share class hedging in UCITS-style funds, many managers target 95–105% hedge with rebalancing at least monthly and keep residual exposure well below regulatory tolerance levels. That discipline is essential to avoid NAV errors.

Dealing with illiquid and EM currencies

NDFs: check holiday calendars, central bank announcements, and the fixing methodology (e.g., WMR 4pm London, RBI Reference Rate) because settlement outcomes can surprise newcomers.

Proxy hedging: if liquidity is poor (say, a frontier currency), consider hedging with a correlated basket (e.g., regional or commodity-linked proxies). This introduces basis risk—measure it and disclose it.

Partial hedging: for volatile EM currencies with costly carry, a 25–50% hedge can materially reduce risk without crushing returns.

Case studies and examples

Case 1: USD investor, EUR share class, JPY assets

Portfolio: 70% Japanese equities (JPY), 30% European equities (EUR).

Fund base/share class: EUR (unhedged share class).

Investor base: USD.

Unhedged, a 10% JPY rally vs EUR boosts the fund’s EUR NAV; a concurrent 8% EUR drop vs USD can offset much of that for the USD investor. If the investor hedges EUR/USD at their account level, they still carry JPY exposure via JPY vs EUR embedded in the fund. Better approach: ask the manager for a USD-hedged share class or run a custom overlay hedging both EUR and JPY exposures back to USD based on look-through weights.

Case 2: Australian pension fund with a 50% strategic hedge on global equities

Base: AUD.

Rationale: AUD is a commodity-linked currency with its own cycles; leaving some foreign currency unhedged provides diversification during local downturns.

Outcome (illustrative): Over a decade, the 50% hedge reduced equity portfolio volatility by roughly 15–20% compared with unhedged, while long-run returns were similar after fees. In years when AUD rallied strongly, the hedge preserved gains; when AUD fell, the unhedged portion softened the blow in the local economy. The board could live with the balance.

Case 3: Global bond fund hedged back to USD using CCS

Portfolio: Mix of EUR, GBP, JPY bonds.

Method: Use cross-currency swaps to convert coupons and principal to USD; maintain duration profile in USD.

Benefit: Lower currency noise and cash flow certainty for distributions.

Nuances: Basis moves impacted all-in yields; collateralization in USD created stable liquidity needs. A small overlay of forwards handled flow timing and residuals.

Numbers to make it concrete

Suppose a USD-based global equity fund holds 40% EUR assets and 20% JPY assets, with the rest in USD and GBP. The manager sets a 50% hedge on EUR and JPY:

EUR/USD carry: +1.5% annualized; JPY/USD carry: +4% annualized (illustrative).

Expected carry pickup from hedges: 0.5 × (0.4 × 1.5% + 0.2 × 4%) = about 0.7% per year before costs.

If EUR and JPY fall 8% and 12% vs USD respectively, the hedge recoups roughly half those moves on the hedged portion, reducing drawdown by about 6–7 percentage points versus unhedged.

Performance measurement and reporting

You’ll get better decisions—and happier investors—if you separate asset returns from currency effects.

Benchmarks

Equity: compare unhedged MSCI ACWI with MSCI ACWI 100% hedged to base or a custom 50% hedged index.

Bonds: global aggregate hedged vs unhedged versions (most bond managers use the hedged benchmark).

Attribution

Asset selection/market.

Currency spot effect.

Carry/forward points and roll.

Execution slippage (spread, market impact).

Share class reporting

Clearly disclose whether the share class is hedged, how frequently it’s rebalanced, and the target hedge ratio range.

Explain that hedged share classes aim to neutralize, not profit from, FX. Residual exposures and costs happen.

I like to show a simple “currency line item” in monthly factsheets: hedge ratio by currency, realized carry year-to-date, and any notable basis/roll effects. It builds trust.

Risk management and controls

Counterparty risk

Diversify dealers; monitor CSA thresholds and ratings.

Wrong-way risk matters: avoid concentration with dealers exposed to the same macro shock as your largest currency position.

Liquidity and margin

Run stress tests: what is the cash call for a 10–15% FX shock? Does your cash buffer or credit line cover it?

Align roll schedules with liquidity windows; avoid bunching large rolls on the same value date if you have redemption risk.

Operational controls

Pre-trade approvals, independent confirmation, same-day reconciliations.

Clear cut-offs for trade entry and allocations across funds/share classes.

Have a playbook for settlement holidays and unusual fixings (NDF quirks).

Regulatory guardrails

UCITS/AIFs: hedged share classes must reduce FX risk without altering the fund’s risk profile; rehedge frequency is typically at least monthly with tight tolerances.

Derivative exposure and leverage must be captured in the fund’s risk framework (e.g., commitment or VaR approach).

Cyber/resilience

FX systems and OMS connectivity are prime targets; segment permissions, and test BCP regularly. A missed roll can turn into an NAV error quickly.

Tax and accounting considerations

FX gains/losses at fund level may be treated as ordinary income or capital depending on jurisdiction and instrument. Cayman-domiciled master funds feeding into UCITS or 40 Act vehicles require careful coordination with tax advisors.

Options premiums and swap payments can have different character than forward gains. Don’t assume symmetry.

Investor-level tax outcomes can diverge from fund-level accounting; disclose clearly in offering docs.

Accounting

Most funds mark FX derivatives to market in NAV; hedge accounting (IFRS 9) is rare in pooled funds but can matter for insurance and pension accounts.

NAV errors frequently arise from stale FX rates, misapplied forward points, or incorrect allocation between share classes.

Match the FX rate used for security pricing with the rate used for hedge valuation to avoid spurious P&L.

Common mistakes and how to avoid them

Hedging the wrong layer

Mistake: hedging the share class currency but leaving the larger portfolio currency risk untouched.

Fix: map exposures meticulously and decide which layer you’re targeting.

Set-and-forget hedge ratios

Mistake: never revisiting a 100% hedge ratio during periods of extreme basis or costly carry.

Fix: use policy ranges and revisit quarterly.

Ignoring flows and corporate actions

Mistake: over-hedging after a big redemption or during a corporate action that changes currency exposure.

Fix: integrate trade order and transfer agency data; impose pre-trade checks.

Tenor mismatch

Mistake: rolling everything on the same day monthly, leading to concentrated fix risk and slippage.

Fix: ladder maturities; distribute rolls.

Counterparty concentration

Mistake: 80% exposure with one dealer due to “best price” habit.

Fix: allocate tickets across approved dealers; monitor exposure limits.

Option misuse

Mistake: buying long-dated options into high implied volatility when you really needed short-term protection or a collar.

Fix: align instrument choice with the risk window; consider structures that cap premium outlay.

Underestimating EM currency complexities

Mistake: assuming NDF liquidity on-requires equals G10—then discovering fixing gaps or holiday mismatches.

Fix: dry-run your settlement calendars and stress the cash flows before sizing up.

Practical checklists

Hedge policy checklist:

Objectives: volatility reduction, tracking error, carry, funding stability.

Hedge ratios by asset class/currency with ranges.

Tenor and ladder policy; roll calendar.

Execution: RFQ protocol, TCA, eligible dealers.

Risk limits: per-currency notional, counterparty limits, liquidity buffers.

Reporting: benchmarks, attribution, disclosure for share classes.

Governance: approval thresholds, exception handling, stress playbook.

Operational checklist:

Daily exposure file with look-through and pipeline trades.

FX rates source aligned with security pricing times.

Automated alerts for hedge drift beyond ±5%.

CSA thresholds, eligible collateral, and available cash tested weekly.

Month-end roll list, allocations, and reconciliations signed off by independent ops.

Contingency plan for dealer outage or settlement disruption.

When hedging might not be worth it

Long-horizon investors with multi-currency liabilities

If you expect to spend in multiple currencies (e.g., global endowment grants), leaving some exposure unhedged can be sensible.

Persistent negative carry

If your base currency yields much less than your portfolio currencies, a full hedge can be a performance drag. A partial hedge may offer a better volatility/return trade-off.

Small or transient exposures

Hedging tiny or short-lived positions can cost more in spreads and ops than the risk it removes. Materiality thresholds help.

EM currencies with poor liquidity

Consider partial hedges or proxies rather than forcing a perfect hedge with high costs and tracking error.

A few data points to anchor expectations

BIS estimates daily FX turnover around $7.5–7.9 trillion in recent triennial surveys—liquidity is deep for G10, patchier in EM.

Over long periods, hedging developed-market currency risk in global equities has reduced volatility by about 20–30% for USD, EUR, GBP, and JPY-based investors with limited impact on mean returns.

For bonds, currency volatility often dominates duration risk; most global bond portfolios are heavily hedged to meet their benchmark risk characteristics.

Bringing it together

You don’t have to be at the mercy of currency swings. Decide what role currency should play in your strategy, put in place a clear policy with practical guardrails, and build a consistent process for execution, rebalancing, and reporting. Whether you choose 0%, 50%, or 100% hedged for a given exposure is less important than being intentional and disciplined.

The approach that works best in offshore structures is usually layered:

Portfolio-level hedging to manage the real economic exposures.

Share class hedging to align investor experience with their chosen currency.

Investor-level overlays for bespoke needs.

The common thread is clarity—about exposures, costs, and outcomes. Get that right, and currency becomes a tool in your kit instead of a source of surprises.