The prevailing volatility in FX markets poses a threat to traded life policies (TLPs), warned Jeremy Leach, managing director of Managing Partners Limited MPL. Speaking before an industry conference in London, he advised funds that invest in TLPs to use a mixture of currency hedging strategies to deal with the problem.

Leach told delegates at the Insurance-Linked Securities Summit conference held at the Meridian Hotel in Piccadilly, London, that chronic FX volatility now posed the greatest liquidity risk for TLP funds. TLPs are United States-issued whole of life policies sold before maturity so that the original policyholders can enjoy some of the benefits in their own lifetimes.

Funds that invest in TLPs are designed to deliver smooth, predictable returns in an investor's base currency. Because TLPs are dollar-denominated assets, this means the currency risk must be hedged for sterling and euro investors.

Leach said: "The most cost-effective way to hedge currency risk is by purchasing forward foreign exchange transactions. But a 'Forward' either creates cash or consumes cash, depending on whether the dollar strengthens or weakens. If a currency pair, such as dollar-sterling or dollar-euro, moves significantly in an adverse way then that creates an enormous liquidity burden on a fund by eating away at the cash reserves.

"When currency pairs are as unpredictable as they are now, with the stability of sterling threatened by the prospect of a hung parliament and the euro undermined by the Greek, Spanish and Portuguese credit risks, then a blend of options and forwards are needed, especially when the volatility has been ongoing for so long."

Forwards are a type of derivative that lock in the price at which two parties are obligated to buy and sell a specified amount of currency on a particular date and at a set exchange rate. When purchased in the correct ratio to a currency pair such as Pounds and Dollars they offset any positive or negative currency trend. Forwards are comparatively cheap to buy because they cover both sides of the trade and so they have nominal impact on net asset values.