When hedging currency risks using forwards and futures, collateral is required to ensure the counterparty is held whole in case of losses from hedging activities. In a recent paper, Swiss-based QCAM Currency asset manager discusses the issue generally and lays out different aspects relating to the problem of collateral management.
The more obvious approaches include netting of trades and positions to avoid holding offsetting positions, using central clearing (e.g. prime brokerage) where the investment amount is sizeable, and collateral optimization where the most effective assets are posted as collateral to name a few. Specific approaches to collateral reduction include: portfolio hedging, proxy hedging, using options, and employing a third-party guarantor.
On “zero collateral hedging”, QCAM wrote: “Even though we hear of zero collateral or collateral-free hedging, we are not convinced that such mechanisms can be implemented unless there is compensation for the costs to the party providing the guarantee for loss protection…Such risk must, in our view, be compensated for whereby one effective means to this end would be inter-product or inter-company cross-financing using a cost-center approach to accurately measure product performance.
“Our experience at QCAM tells us that the level of collateral required or whether assets can be pledged and with what level of haircut (margin of safety) is very much a matter of discussion between the counterparties and it is worthwhile exploring multiple trading partners to arrive at the best possible solution.”