Hedging EUR Bond Cash Flows with Currency Forwards

Summary

The document asks how to hedge foreign exchange exposure on a long-dated EUR bond while retaining interest rate exposure. Its answer recommends hedging the bond’s future cash flows with a fixed-for-fixed currency swap, which can be viewed as a series of forward exchanges. This is a cash flow hedge: it converts the payments into another currency while shifting the associated interest rate exposure into that currency’s rates.

The answer distinguishes this from hedging the bond’s present value, described as fair value hedging with a fixed-for-floating currency swap. For variable-rate bonds, it notes that a basis swap can provide a similar cash flow hedge, while a float-for-fixed structure can also change the interest rate exposure. A second answer suggests discounting the maturity amount and future payments, but the document does not develop or reconcile that suggestion. It gives no worked valuation, hedge ratios, or treatment of practical details such as reset dates and basis risk.

Key ideas

• A cash flow hedge targets the bond’s future payments rather than a single future value.
• A fixed-for-fixed currency swap can be treated as a series of forwards that exchanges cash flows into another currency.
• The hedge shifts interest rate exposure into the currency of the replacement cash flows.
• A fair value hedge uses present value and is associated here with a fixed-for-floating currency swap.
• A basis swap may be used for a similar cash flow hedge on a variable-rate bond.

Tags

# EUR issuance using forwards to hedge FX risk


# EUR issuance using forwards to hedge FX risk












Trying to think about the right way to hedge a EUR denominated issuance from FX risk only. Say I have an annual pay 20-year EUR bond and I want to hedge the FX risk but take the interest rate risk. I would be hedging using forwards, say 3m.

What value of the bond should I hedge, present value or future value?

## Answer by PBD10017 (score 1)

https://quant.stackexchange.com/a/25197

You need to hedge future cash flows (not future value) using a fixed for fixed currency swap (equivalent to a series of forwards). This translates into a "cash flow hedge". Hedging present value would be hedging the "fair value" of the bond with a fixed-for-float currency swap. Using a fixed for fixed swap will convert your cash flows into desired currency (e.g. USD or GBP) and will convert EUR interest rate risk into that currency's interest rate risk. Hence you will not "hedge" your interest rate risk, but you will convert it from one currency's interest rates to another. It is impossible to have cash flows in one currency and interest rate risk based off of a different currency.

If your bond is variable rate you can use a basis swap to achieve the same type of cash flow hedge as before. If you use a float-for-fixed swap you will convert this into a interest rate hedge as well.

## Answer by rupweb (score 0)

https://quant.stackexchange.com/a/25180

To hedge the EUR value without interest rate risk then you'd use the net present value of the EUR face value you receive at maturity, and add the NPV of all the discounted future cash flows, right?

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.