How to Create an FX Risk Management Strategy
Updated: Sep 15, 2020
Hindsight is 20/20 - ironically 2020 is set to be the most volatile year since 2008. Markets are red across the board for the year and the world is slowly emerging from lockdown to face an economic crisis.
DON'T 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.
FX Risk Management Strategy Checklist
Quantify your FX Risk
What is your worst-case scenario rate?
What is your appetite (and do you have permission) to achieve better than this rate?
Product selection through simulation
Why have the currency markets been so volatile?
This is not just because of COVID-19…We’ve been in the midst of a two-year-long trade war between the two largest economies in the world, with impacts to supply chains worldwide.
The EU and the UK have been roiling the markets even longer with Brexit, terms of trade, potential Irish unification, and a Scottish exit. OPEC is a shambles, resulting in an oil price crash that has sent tremors throughout the equity markets, which are still being felt today in commodity currencies. In many countries, consumer confidence, industrial production, PMI and other indicators show widespread weakness. COVID-19 was simply the tipping point of longer-term trends, the straw that broke the camel's back
What does a currency move mean to me?
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 indication of the limitations of the worst case.
For example, a VaR of $1M means that 90% of the time your losses will not exceed $1M.
How to calculate VaR?
Assuming that market returns are normally distributed, you can use the volatility of the historical market returns to calculate your VaR.
populate a column with daily historical spot values (you can copy and paste daily fx rates from OFX)
In the next column, calculate the log returns (this normalizes the data).
Use the Excel function stdev(log returns) to calculate the standard deviation (= volatility).
Convert this daily volatility to annual by multiplying by sqrt(252).
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 annual VaR.
Now that I know my FX risk, what’s next?
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, then the risk manager will experience liquidity problems. This is where hedging is useful.
It is important to remember that your main responsibility is to your shareholders and that you are paid to import widgets, grow revenues or provide investment returns. Currency speculation is unlikely to be a part of your strategy.
I’ve decided on what I want to do, now what?
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.
Forwards are the most common hedging instrument. There are two types of forwards:
Closed or outright forwards - must be settled on a fixed date in the future. They allow the hedger to take advantage of favorable forward pts if available. NDF’s are a form of outright forwards.
Open or window forwards - Allow the hedger to lock in an exchange rate and drawdown payments over a period of time at a fixed rate without any penalty.
Both sets of forwards allow the hedger to protect their budget rate for up to 24 months in many cases. The rate that’s locked in is the current spot rate plus “forward points” that depend on the relative interest rates of the two countries. As central banks race to cut their rates and stimulate the economy, forward points are falling, creating an ideal hedging environment.
Like a forward contract, a futures contract is an agreement between two parties to buy or sell an asset (in this case, the exchange rate) at a certain time in the future for a certain rate. Unlike forward contracts, futures contracts are normally traded on an exchange, also they are a standardized contract, that means, having an exchange-specified contract unit, expiration, tick size, and notional value. The counterparty risk is low as they are exchange-traded however rigid contract sizes and daily margin requirements can make them hard to manage.
Options are another alternative. At the expense of a premium, they protect the downside whilst allowing participation in the upside. Pricing is opaque and expensive so they may only be a good alternative for firms with high-profit margins and therefore a higher risk tolerance.
Using Long-term debt instruments
For long-term exposures which are long the local currency (eg a US firm selling products or services in the EU), the use of debt instruments (bonds, loans) can offset FX risk. The process is simple. The firm takes out a local currency (LC) obligation such as a bond and converts the proceeds to its reporting currency (RC). The proceeds can be used to fund operations, R&D, etc. Instead of hedging or converting its LC revenues to RC, it uses them to service the LC debt obligation. In this way, it eliminates the FX risk of its revenues and the debt instrument simultaneously.
Selecting the size of the debt instrument is based on the long-term baseline value of LC revenues, so there will always be residual LC revenues that still are at risk, but the net is much lower.
Using Cross-currency swaps
Cross-border investments and cross-border issuance are exposed to interest rate risk and FX risk. Similar to an Interest Rate Swap but where each leg of the swap is denominated in a different currency. A Cross Currency Swap, therefore, has two principal amounts, one for each currency. Using cross-currency swaps can help institutions retain core longer-duration assets to manage interest and currency rate risk.
The number, size and tenor of the instruments used are determined by the methodology. While there are several well-known methods, layering forwards produces the most reduction in volatility as measured period over period. Things can get even more complex, with portfolio hedging and other more advanced methods that can reduce the cost of hedging while preserving its efficacy.
How much will FX risk management cost me?
How much it “costs” to hedge depends on a great many factors.
Using forwards when both currencies are major (e.g. GBP, USD, EUR, CAD, AUD, NZD, CHF) is essentially free. Forward points are currently almost zero, and the only “cost” may be a margin deposit. If one or both of the currencies are in an emerging market (eg BRL, INR, MXN), then the annual cost may be as much as 5% of the notional being protected. However, as mentioned above, as central banks cut rates, forward points are falling.
Option premiums are a function of volatility. In high-volatility environments, option premiums can be quite expensive. Using combinations of long and short options can reduce the net premiums paid (see Monte Carlo discussion below).
Not managing FX risk, is speculation, pure and simple. Hope is not a strategy, and betting the farm on some Fibonacci retracement is equally unwise.
Deaglo 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.
Deaglo can help with hedge product selection and evaluation. Our Monte Carlo engine can simulate not only a normal market, but one with elevated volatility, fat tails, or even skewed up or down. 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.
Margin Requirement Analysis
In derivatives markets, variation margin is one of two types of collateral required to protect parties to a contract in the event of default by the other counterparty. Unexpected variation margin payments can definitely frighten organizations off.
By using Monte Carlo simulation, Deaglo 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.
Once determined the optimum hedge strategy, the variation margin model can assess the moneyness for every derivative in the selected strategy. For instance, when evaluating a multi-legged strategy such as a Seagull, all three legs must be evaluated at every point of every path generated by the first Monte Carlo Simulation. This is because at each point, some of the options will be in the money, some out, and some may be out of the money.
Therefore, using a variation margin model that shows the likelihood and levels that will trigger these requirements, it will substantially help companies plan and optimize funds to meet any margin calls.
Over the years our team established relationships with a number of execution partners. These relationships, their preferential transaction rates, and 0% credit facilities* are extended to our clients no matter the transaction size or annual volume. Substantially reducing the time spent on unnecessary vendor selection.
We empower finance and investment teams with tools needed to effectively transact overseas, allowing you to focus on your core business strategy.
*0% facilities are based on an entity’s financials and are looked at on a case by case basis. Deaglo has successfully negotiated a number of 0% facilities for our clients but it cannot be guaranteed and is subject to the banking provider's risk appetite.