A secured currency forward priced the way a facility counts it, at inception and after an adverse year.
Where a subscription facility secures the fund's hedges, the lender counts each hedge's exposure, its current mark-to-market owed by the fund plus a potential future exposure add-on, against availability. For an illustrative three-year forward selling $216 million (€200 million), a 9 per cent volatility at 95 per cent confidence gives an add-on of 25.6 per cent, so the hedge uses €51.3 million, 36.6 per cent of the fund's €140 million of headroom, before the dollar has moved at all.
Worked in full in The Fund Finance Professional by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Many subscription facilities let the fund enter currency and interest rate hedges with the lending banks and secure them on the same collateral as the loans: the investors' uncalled commitments. That is convenient, because the fund does not have to post cash margin, but the hedge banks rank alongside the lenders and the borrowing base has to cover both. The usual mechanism is to deduct a hedge exposure amount from availability, calculated under the facility's own definition. That definition varies by agreement; the version below, mark-to-market plus a volatility-based add-on, is a common shape and is illustrative.
| Item | Value |
|---|---|
| Facility commitments | 400 |
| Borrowing base | 480 |
| Loans outstanding | 260 |
| Headroom before the hedge | 140 |
| Hedge: USD sold forward | $216m |
| Spot EURUSD | 1.08 |
| Hedge notional in euros | 200 |
| Tenor | 3 years |
| EURUSD volatility, annual | 9% |
| Confidence factor, 95% one-tailed | 1.645 |
The fund is a euro-denominated buyout fund that has bought a US company and hedges the expected dollar exit proceeds forward. Availability is the lesser of the facility and the borrowing base, 400, less the 260 drawn, which leaves 140. The volatility and the confidence level are illustrative inputs; the hedge banks set their own. For simplicity the forward rate is taken equal to spot and the mark-to-market below is undiscounted.
Hedge exposure = max(mark-to-market owed by the fund, 0) + potential future exposure
Potential future exposure = notional × volatility × √(remaining tenor) × confidence factor
Add-on = 9% × √3 × 1.645 = 9% × 1.732 × 1.645 = 25.6%
Exposure at inception = 200 × 25.6% = 51.3 (mark-to-market is zero on day one)
Headroom after the hedge = 140 − 51.3 = 88.7
Excel: =B7*B9*SQRT(B8)*B10 for the add-on, and =MIN(B1,B2)-B3-MAX(B11,0)-B12 for headroom.
The square root of time is what makes the tenor matter. A dollar move compounds with time, so a three-year hedge carries an add-on 1.732 times that of a one-year hedge, not three times. The add-on then falls as the hedge ages, while the mark-to-market moves with the market.
On day one the hedge uses €51.3 million, 36.6 per cent of the headroom, and the fund can draw 88.7 rather than 140. Now suppose that after one year the dollar has strengthened by 8 per cent, taking EURUSD to 1.00. The fund has sold dollars forward, so the hedge is a liability: the $216 million it must deliver now costs €216 million, a mark-to-market loss of €16.0 million. The add-on on the remaining two years falls to €41.9 million.
| Point in time | Mark-to-market owed | Add-on | Exposure | Headroom left | Share of headroom |
|---|---|---|---|---|---|
| Inception | 0.0 | 51.3 | 51.3 | 88.7 | 36.6% |
| Year 1, no move | 0.0 | 41.9 | 41.9 | 98.1 | |
| Year 1, euro up 8% | 0.0 | 41.9 | 41.9 | 98.1 | |
| Year 1, dollar up 8% | 16.0 | 41.9 | 57.9 | 82.1 | 41.3% |
The asymmetry is the point. When the dollar weakens, the hedge is an asset worth €14.8 million to the fund, but exposure only counts amounts the fund owes, so it does not release headroom. When the dollar strengthens, the loss is added in full. The worst moment for the fund's liquidity is a strong dollar, which is also the moment the underlying US asset is worth more in euros: the hedge is working, but the gain sits in an unrealised investment while the loss sits in the facility.
| Tenor | Add-on | Exposure | Headroom left |
|---|---|---|---|
| 1 year | 14.8% | 29.6 | 110.4 |
| 2 years | 20.9% | 41.9 | 98.1 |
| 3 years | 25.6% | 51.3 | 88.7 |
| 5 years | 33.1% | 66.2 | 73.8 |
At a 7 per cent volatility the three-year add-on is 19.9 per cent, €39.9 million; at 12 per cent it is 34.2 per cent, €68.4 million. A shorter, rolling hedge uses less of the line, €29.6 million for one year, but it settles in cash at each roll: an 8 per cent dollar rise would then crystallise the €16.0 million loss as a payment, usually funded by a drawing on the same facility. Some agreements use a flat grid instead of a volatility formula; an illustrative 5 per cent per year of tenor would charge €30.0 million, or 15 per cent, for the same hedge.
On these inputs the fund could hedge at most €546.0 million of three-year notional, about $589.6 million, before the add-on alone exhausted the 140 of headroom. Keeping the full 140 free would mean upsizing the facility by 51.3, at an illustrative 35 basis point commitment fee about €180 thousand a year.
A secured FX hedge uses subscription line capacity equal to what the fund owes on it plus an add-on that grows with the square root of tenor: here €51.3 million on day one for a €200 million three-year forward, and €57.9 million after an adverse year. Size the hedge programme against stressed headroom, not notional. How the base and availability are built for the book's own facility is in the free workbook for this case, and the base itself in how to calculate a subscription line borrowing base.
It is the part of a subscription facility that may be used by hedges secured on the investors' uncalled commitments, with each hedge's exposure deducted from availability. In the illustrative case a three-year forward with a 200 million euro notional is counted at 51.3 million, its potential future exposure, rather than at its notional.
A simple version multiplies notional by annual volatility, the square root of the remaining tenor and a confidence factor, 1.645 at 95 per cent. At 9 per cent volatility and three years the add-on is 25.6 per cent of notional; at one year it is 14.8 per cent and at five years 33.1 per cent.
Usually not, because exposure counts only what the fund owes. In the worked case a weaker dollar makes the hedge worth 14.8 million to the fund but exposure stays at the 41.9 million add-on, while a stronger dollar adds a 16.0 million loss and takes exposure to 57.9 million.
This article is one calculation from The Fund Finance Professional. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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