How to Create an FX Risk Management Strategy
Updated: Dec 7, 2021
Currency fluctuations affect the cost competitiveness, profitability, and valuation of a company's international operations. Although many companies are aware of the currency risk and its negative impacts, they refrain from creating a Foreign Exchange (FX) Risk Management Strategy, leaving the company unprepared when it comes to controlling the potential adverse effects of currency movements.
Overall, global corporations and fund managers are facing increased currency risk in recent years across all currencies after the world was hit by the Covid-19 pandemic, and although global economic recovery is taking place, challenges continue to persist, including the current energy crisis, geopolitical conflicts, and political instability.
HOWEVER, THERE IS NO NEED TO PANIC - In times of uncertainty, it is important to remember that you can only control what you can control, and having an effective FX risk management strategy can help alleviate a lot of the anxiety when transacting overseas.
In this article, we will explain how our technology helps to quantify and analyze such FX risk, as well as describe the tools and approaches that we use to hedge and manage these FX risks.
FX Risk Management Strategy Checklist
Step 1 - Quantify my FX Risk
The first step in managing FX risk is quantifying it. Is it material? Will it harm my business or investors? One of the most common measures is Value at Risk (VaR). VaR is an attractive measure because it is easy to understand. In essence, it asks the simple question - ‘‘How bad can things get?’’.
In other words, the VaR states the maximum possible loss at a given confidence level. For example, a VaR of $3M means that 90% of the time your losses will not exceed $3M in a one-month period.
How do you calculate VaR?
Assuming that market returns are normally distributed (Fig. 1), you can use the volatility of the historical market returns to calculate your VaR. Historical simulation is one popular way of estimating VaR. It involves using past data as a guide to what will happen in the future.
Figure 1. Example of a normal distribution
Populate a column with daily historical spot values.
In the next column, calculate the log returns (which will help normalize the data).
Use the Excel function stdev(log returns) to calculate the standard deviation (= volatility).
Convert this daily volatility to monthly by multiplying by sqrt(21).
Finally, using the Excel function normsinv(90%), calculate the number of std deviations of the desired confidence, multiply by the volatility and the size of the exposure.
The result is the month VaR (Fig. 2). Figure 3 illustrates the VaR in the probability distribution chart.
Figure 2. Calculating VaR on Excel
Figure 3. Calculation of VaR from the probability distribution of the change in the currency value; with a confidence level of 90%.
Step 2 - Setting my worst-case scenario rate
Most firms will have set a “Budget Rate” (aka planning rate), which is a conservative estimate of the future exchange rate. It’s used to set prices in local currency and estimate future revenues or returns in the firm’s reporting currency. Depending on the firm’s margins or expected returns, an additional buffer may be added. This is the rate that needs protecting - if it’s breached, the risk manager will experience liquidity problems. This is where hedging is useful. A budget rate should be achievable through hedging.
Reminder: Your main responsibility is to your shareholders, and you are paid to import widgets, grow revenues or provide investment returns. Currency speculation is unlikely to be a part of your strategy. Outperformance is welcomed, but generally not the policy objective.
Step 3 - Understanding the derivative tools available
You've decided to use hedging to protect your firm or investors. There are many instruments and methodologies to choose from.
FX hedging Instruments include:
Long-term debt instruments
Each has advantages and disadvantages, and the choice depends on both the firm's risk profile and margins. What’s more, you will need to get buy-in from either your board, shareholders, investors, or all of the above, so it probably makes sense you understand them.
Need some help? Talk to an expert today.
Step 4 - Selecting my FX strategy through simulation
Not managing FX risk, results in speculation, pure and simple. Hope is not a strategy and betting the firm on some Fibonacci retracement is equally unwise.
Multinational corporations and global fund managers are facing increased currency risk as volatility has significantly increased in recent years across all major and exotic currencies after a prolonged period of relatively range-bound activity. CEOs, CFOs, finance teams, and corporate boards continue to face scrutiny from stakeholders and investors regarding the effectiveness of risk management policies to mitigate currency risk and protect shareholder value.
We can act as a valuable partner during times of uncertainty. Organizing and presenting the facts in a clear and concise way can help speed up the decision-making process by removing the emotion out of a stressful situation.
Figure 4. Strategy selection and comparison
Our technology can help with hedge product selection and evaluation (Fig. 4). Our Monte Carlo engine technology can simulate not only a normal market, but one with elevated volatility, fat tails, and even a skewed up or down option. Evaluating strategies against many market scenarios, and displaying the results in an easy-to-understand graphical manner, makes it easy and intuitive to select the best strategy and communicate the reasoning to C-suite and investors.
Moreover, we will provide you with a full explanation of hedging products, the benefits, drawbacks, costs, and so on. All the details you need, for you to make the right decision.
Step 5 - Calculating the cost of your FX strategy
When discussing hedging costs, we need to make a clear distinction between hedging impact and trading costs.
Here, we are discussing the cost related to the interest rate differential (put simply, forward points), which can either incur a carry cost at the inception of the hedge or a credit.
For instance, using forwards when both currencies are major (e.g. GBP, USD, EUR, CAD, AUD, NZD, CHF) are essentially free. Forward points are currently almost zero. If one or both of the currencies are in an emerging market (e.g. BRL, INR, MXN), then the annual cost might reach over 8% annually (Fig. 5).
Figure 5. The forward curve for the USDBRL
Trading costs can be defined as the bid-ask spread that is earned by the counterparty or financial institution on the other side of the trade. For instance, when entering into a forward contract, you need to make sure both the spot rate and the forward points or interest rate differential between the two currencies are priced appropriately.
Other trading costs include the collateral required to protect parties to a contract in the event of default by the other counterparty. When trading standardized derivatives, you will be required to post the initial margin and variation margin with the counterparty.
Thus, initial margins and variation margins are two types of collateral required to protect parties as mentioned earlier.
In this sense, an unexpected negative variation margin of positions may introduce new risks to the company's cash flow. This is often accompanied by the need to post financial deposits (this requirement is also known as margin call) to cover negative positions, directly impacting the availability of the company's financial resources.
Unexpected variation margin payments can definitely frighten organizations off. Although it is not possible to eliminate 100% of the possibility of margin calls (except for long options), there are statistical tools that companies can adopt to estimate the likelihood of the occurrence of inconvenient margin calls in advance.
By using the Monte Carlo simulation (Fig. 6), our technology can model the probability of different outcomes in a situation that cannot easily be described in a closed-form equation. It is often used to understand the impact of risk and uncertainty in prediction and forecasting models.
Figure 6. Monte Carlo simulation
Once you have determined the optimum hedge strategy, the variation margin model can assess the moneyness for every derivative in the selected strategy (forwards, options, exotic options, etc.). Therefore, using a variation margin model that shows the likelihood and levels that will trigger these requirements, will substantially help companie