A perfect storm
Hans Jacob Feder
The scene was set for heightened currency volatility as we entered 2025. Aside from a new US president promising to upend global trade agreements and reverse many of the previous administration’s policies, markets were braced for federal elections in Germany and economic concerns in France and the UK.
Few foresaw how extreme the fallout would be. Between 9 April and 12 May, the US slashed tariffs on Chinese imports to 30% from 145%, while Beijing reciprocated, cutting its duties to 10% from 125%.
The historic flip-flop sent the CME Group volatility index for G5 currencies up over 65%, and then down more than 35%. Meanwhile, the US Dollar Index (DXY) dropped 7% year to date as of 16 May – including a 4.3% decline following “Liberation Day” on 25 April, when higher US tariffs were formally announced.
Currency volatility isn’t new, but the speed and scale of the moves have forced many investors to reevaluate how they manage FX exposure.
“Today’s market conditions have focused attention on minimising the impact of volatility, the cost of which is often overlooked by portfolio managers focused on their investment returns,” said Hans Jacob Feder, global head of FX services at MUFG Investor Services.
The increased demand for FX hedging comes as currency markets have already grown significantly in recent years. According to the latest data from the International Swaps and Derivatives Association (ISDA), the notional volume of FX derivatives grew by almost 10% between January and June 2024 compared to the same period a year earlier.
Typically, FX is seen as a second-order risk. Only once firms are confident in their investment operations do they turn to their FX and other factors not considered fundamental to the investment strategy. But growing uncertainty is fuelling increased interest in currency overlay from hedge funds and private equity firms, who want to make sure they get their hedges right in the months ahead.
“The immediate focus might be on rebalancing investments rather than putting overlay programs in place, but as markets calm down, the importance of having a plan to manage future FX volatility will come to the fore again,” adds Feder.
From afterthought to ally
Most asset managers already hedge FX risk to some degree. Long-only managers typically use hybrid models, combining internal and external resources. Hedge funds lean heavily on outsourced FX solutions to stay lean and focused on front-office returns.
But private equity firms are seeing a more striking shift. Once shut off from FX overlay programs – because bank credit departments required daily variation margin – these firms can now often delay settlements until contract maturity. This has made FX hedging more viable for illiquid strategies, and the associated credit lines more accessible to private equity.
All three investor types are turning to service providers with primary expertise in FX for advice on how to think about today’s uncertainties. In the post-mortem since Liberation Day, the focus is not just on how much of a portfolio should be hedged, but how to amend hedges so they work more efficiently – and how to offer end-investors a clearer explanation for why one share class might have outperformed another.
“Right now, everything is flashing red, and people are firefighting. But when it calms down, they’ll figure out what went wrong and how they want their hedges to behave next time,” said Feder.
Precision and transparency
As institutions adapt, the new standard is clear: FX overlay solutions must be automated, transparent and fully integrated. That means linking directly with custodians and data sources, assuming full responsibility for calculations and execution, and running on autopilot once the foundational parameters are set.
Execution quality and cost transparency are key. While spreads remain tight – bid-offer spreads have moved less than 10% since April – providers differ dramatically in how they execute. Some route trades to internal flow or a single dealer, creating conflicts of interest and potentially increasing costs.
In contrast, MUFG Investor Services streams two-way prices from multiple banks, selects the best quote within milliseconds, and executes trades under its own name. It then stands between the liquidity providers and the client, giving the clients the benefit of multi-bank execution while only facing MUFG as the counterparty. There will be growing demand for such multi-bank liquidity and counterparty risk management solutions, Feder noted.
Pricing is so far relatively stable when it comes to the fees provided for the hedging service. But volatility can drive frequent hedge rebalancing, which adds to trading activity. This is particularly impactful for US-centric portfolios, as the dollar features in an estimated 88% of global FX transactions. Repeated hedge adjustments – especially during sharp reversals – can inflate costs without meaningfully reducing risk.
In these scenarios, it is useful to remember that overlay adds value regardless of dollar direction. For example, MSCI research last year found that US-based investors who hedged FX risk between 2010 and mid-2024 experienced lower volatility and higher returns than their unhedged peers.
Equally important is picking the ideal time of day for optimal liquidity. While securing best execution in the forwards market is more complex than in spot markets, it is achievable with the right infrastructure. Certain times of day – when Asia’s trading day is ending, London’s afternoon is underway, and New York is waking up – represent some of the most liquid periods, Feder notes. This can be critical for investors with a regulatory obligation to secure the best possible price.
Customisation and control
A tailored overlay strategy begins by defining objectives: Is the goal to reduce risk, enhance returns – or both? Managers must then determine whether to focus only on developed markets or include emerging ones. As allocations to emerging markets grow, programs must address complexities such as access to historically restricted markets and the management of non-deliverable forwards (NDFs).
Cash flow management is a growing concern. Investors should assess how routine cash flows will be handled and whether liquidity constraints need to be addressed in the program design. An experienced manager can help define strategic goals, implement best practices, navigate regulatory requirements, manage onboarding and build a robust counterparty framework.
Collateral flexibility is another focus for managers. MUFG Investor Services, for instance, now has several solutions tailored to handle the credit risk including synthetic margin, account control agreements and deeds, as well as “clean lines” that might be available depending on the structure and investment profile of the client fund.
When it comes to measuring performance, transaction cost analysis (TCA) helps ensure that execution quality aligns with agreed-upon benchmarks and fee structures, offering transparency and accountability around trade implementation. But TCA should be just one piece of a broader framework. It needs to be complemented by performance attribution, volatility analysis, cash tracking and assessments of how consistently hedge ratios are maintained.
While execution costs may only run a few basis points, forward point differentials – driven by interest rate spreads – can affect returns by several percentage points. Attribution analysis helps decode these effects and ensures accurate program evaluation.
Firms using currency overlay must also consider its impact on financial reporting. Derivatives used to mitigate FX risk may require additional disclosures about the types of products used, their effect on returns, and any changes to liquidity requirements or carry costs.
Next-generation hedging
Custodians are well positioned to implement overlay strategies due to their proximity to client portfolio exposures and streamlined settlement processes. Fund administrators also play a valuable role, as their NAV calculations and handling of unit-holder transactions provide crucial data inputs.
However, as overlay strategies grow more complex, the need for specialist providers increases. Customised programs demand dedicated expertise and infrastructure beyond what standard custody or fund admin services offer – especially for alternative funds. While overlay is automated as much as possible to reduce human error, an effective program must allow for real-time adjustments when portfolio conditions change.
“Flexible, cloud-based technology that integrates directly into client systems will become table stakes,” Feder said.
“Clients must be able to focus on the strategic aspects of the overlay program – making upfront decisions about how the hedge should behave and determining what’s best for the fund – rather than worrying about execution.”
