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  • Writer's pictureShahid Bharucha

7 key steps to develop an effective Forex Risk Management Strategy.

Updated: Mar 22, 2023

Currency fluctuations can affect the cost competitiveness, profitability, and valuation of international investments and multinational operations.

Source: WSJ

Moreover, the current macroeconomic environment poses an increased currency risk as a result of elevated inflation worldwide, global monetary tightening, and geopolitical conflicts such as the Russia-Ukraine war, the U.S.-China trade tussles, and chip wars, strongly implying that political instability and high volatility will remain in the short term.

Because of that, global fund managers (GPs), CEOs, CFOs, finance teams, and corporate boards continue to face scrutiny from stakeholders and investors (LPs) regarding their Forex hedging strategy to mitigate currency risk and protect shareholder value; in other words, save the returns against adverse currency movements.

But how does a fund manager (GP) or a CFO achieve that? How much of the portfolio is vulnerable to currency risk? Is there a step-by-step guide for currency hedging?

Fund managers (GPs) and treasury heads find these questions challenging, leaving their international portfolios unprepared to mitigate the negative implications of currency movements. Additionally, currency instability and volatility negatively impact sound international investments and corporate returns.

This essay walks a general practitioner through the process of developing an effective Forex risk management strategy for fund managers (GPs) and corporate finance heads to safeguard their overseas investments and expenditures.

Ultimately, it shows how our technology-powered Investment Platform can assist in assessing and analyzing such Forex risks and the methods and techniques used to hedge and manage them.

Forex Risk Management Strategy Checklist

  1. Quantifying your Forex Risk

  2. Setting your worst-case scenario rate.

  3. Understanding the hedging tools available.

  4. Selecting your Forex hedging strategy through simulation

  5. Calculating the cost of your hedging strategy

  6. Achieving the best execution terms for your optimal strategy

  7. Managing your ongoing Forex exposures

Step 1 - Quantifying your Forex Risk

The first step in controlling Forex risk is determining how much exposure exists and then quantifying it.

In simple words, how much currency is affecting your investments?

Value at Risk (VaR) is one of the most prevalent quantification methods. VaR is a straightforward, appealing metric that addresses the simple question, "How worse can things get?"

In other words, the VaR represents the highest probable loss at a given confidence level.

How do you calculate VaR?

VaR can be estimated in three ways. The first is the historical technique, followed by the variance-covariance method, and the final is to compute using a Monte Carlo simulation.

Our investment platform assists with VaR calculation in two ways. It first calculates the volatility of your preferred currency, which is then multiplied by the desired confidence levels to derive VaR. Second, it allows you to compute VaR using the Monte Carlo simulation approach.

Images for both types of calculations are shown below.

a. VaR using volatility

USDBRL historical price chart with volatility and layered hedging effect.

Figure 2, Source: Deaglo

*USD BRL = 5.1011, Calculating Value at Risk (VaR) using volatility.

Table 1, Source: Deaglo

As shown in the table above, a VaR of BRL 27M suggests that your losses will not exceed 27M BRL or $5.4 MM for the specified period 90% of the time.

Essentially, the technology is designed to show you how much of your portfolio is vulnerable to currency risk and how a layered hedging strategy would smooth out currency fluctuations. Join our waitlist here to access our Investment platform.

b. Var using Monte Carlo Simulation

Computing VaR using Monte Carlo simulation.

Figure 3, Source: Deaglo

The Monte Carlo simulator powered by Deaglo's platform uses machine learning to predict thousands of possible currency movements and compute the portfolio's VaR at any given time.

Step 2 - Setting your worst-case scenario rate

Most corporations will have established a "Budget Rate" (also known as a planning rate), which is a conservative projection of the future exchange rate. It sets local currency prices and forecasts future revenues or returns in the firm's reporting currency.

Depending on the firm's margins or expected returns, an additional buffer may be introduced. This rate must be protected; if it is breached, the risk manager will face liquidity issues. This is when hedging is beneficial. Hedging should be used to achieve a budget rate.

Reminder: As a GP, your primary responsibility is to grow revenues and provide consistent returns to shareholders. Currency speculation is unlikely to be a part of your strategy. Outperformance is welcomed but generally not the policy objective.

Step 3 - Understanding the hedging tools available

Once you have decided to hedge your exposure and protect investors' returns or tight profit margins, there are many instruments and methodologies to choose from.

FX hedging Instruments include

  1. Forwards

  2. Futures

  3. Options

  4. Swaps

  5. Cross-currency swaps.

Each has advantages and disadvantages, and the choice depends on the investors' or fund's risk profile and credit terms.

Moreover, you will need to get buy-in from your board, shareholders, investors, or all of the above, so it probably makes sense that you understand them.

Need help here? Talk to an expert today.

Step 4 - Selecting your Forex hedging strategy through simulation

Choosing the instrument to deploy for hedging and observing its actual result are two distinct things.

GPs can compare and contrast various hedging methods using our investment platform. Monte Carlo simulation is powered to replicate a typical market and one with high volatility, fat tails, and a skewed up or down choice.

Ultimately, it allows the evaluation of several possible market scenarios and displays the results in an easy-to-understand graphical format and its rationale to the C-suite and investors.

One such strategy analysis using Deaglo's investment platform is given below.

Strategy selection and comparison.

Figure 4. Source: Deaglo

Each method has its own set of advantages and disadvantages, and understanding its mechanism, applicability, and costs is essential to make an informed decision.

Do you want to learn more about different hedging methods and their advantages? Talk to an expert today.

Finally, read our case study to understand how our investment platform assisted a fund manager in raising 300% more foreign money by utilizing our hedge share class strategy.

Step 5 - Calculating the cost of your hedging strategy

When discussing hedging costs, you must clearly distinguish between hedging impact and trading costs.

a. Hedging impact

Hedging impact refers to 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), the forward points are currently almost zero, and hedging costs are less.

However, If either of the currencies is of an emerging market (e.g., BRL, INR, MXN), then the annual cost might reach over 8% as the forward points shoot up as the curve becomes steep, as shown in the image.

The forward curve for the USDBRL

Figure 5, Source: Bloomberg

Speaking about forward points, if you are a GP who uses forward contracts to hedge your risks, you should check our (FET) Forward Efficiency Tool. It assists in calculating the efficiency of hedging with forwards while using rolling hedging structures.

b. Trading costs

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 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.

In this sense, unexpected and negative variation margin requirements for your trading positions during adverse market situations 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.

That being said, although it is impossible to eliminate 100% of the possibility of margin calls (except for long options), our investment platform is empowered to estimate the likelihood of inconvenient margin calls in advance. See the image below.

Margin simulator.

Figure 6, Source: Deaglo

Deaglo's platform assists you in modeling the variation margin requirement, which can assess the moneyness for every derivative in the selected strategy (forwards, options, exotic options, etc.). This will substantially help companies plan and optimize funds to meet margin calls.

Not only this, our team has established relationships with many execution partners over the years and has traded $3B so far.

Leveraging those relationships, we have the power to provide tight spreads and 0% credit facilities* to our clients, regardless of the transaction size or annual volume, thus enabling our clients to deal with optimal costs while investing or transacting overseas.

Check out our Margin simulator by joining the wait list here.

*Please note that 0% collateral 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 many clients, but it cannot be guaranteed and is subject to the banking provider's risk appetite.

Step 6 - Achieving the best execution terms for your optimal strategy

So far, Deaglo's investment platform allows you to simulate the optimal currency hedging strategy for mitigating adverse swings.

But the game does not end here. To achieve the optimal strategy, you must have a diverse set of counterparts with the necessary credit and risk appetite.

The general understanding of best execution is usually narrowed to achieving the best price. But that's not true, as when engaging in Forex, fund managers and corporations end up facing other risks by controlling the exposures.

Because fund managers and CFOs are driven by the best price, the most competitive counterparty earns the majority of Forex exposure, which by default increases the counterparty risk and the liquidity at risk of breaching the thresholds of a specific Forex line.

One way to bring balance into the equation and ease the pressure of chasing the best price and understanding the best execution in a holistic way is to pre-define with counterparties fixed spread agreements that guarantee fair pricing and cost control.

Deaglo adds value to their clients by negotiating on their behalf the commercial terms of their Forex trading facilities, including the agreement of fixed spreads ensuring that on an ongoing basis, these are delivered in a reliable and transparent fashion.

Best execution equation.

Figure 7, Source: Deaglo

Step 7 - Managing your ongoing Forex exposures.

The final step is to keep an eye on your current trade positions using reports.

Our clients know that an effective hedge program is not static, just as a company's financial and business risks change. As you grow and become more dynamic, a hedging program must change and evolve with the external environment.

Deaglo's investment platform allows you to monitor and alter your trade positions in response to changing market conditions.

Thank you for sticking with us this far. You may have realized by now that all of the previous steps are critical and must be considered when developing a Forex risk management policy.

Below outlined are the points why this document is essential to create an effective Forex risk management strategy:

  1. First, it establishes a framework for developing a succinct Forex hedging strategy.

  2. Second, it demonstrates Deaglo's investment platform and its deliverables that allow you to quantify your risk, formulate and compare various strategies, assist in the best execution, and lastly, strategy report and evolution in reaction to market conditions.

  3. Third, the document educates management teams (funds and organizations) on Forex risk management, enabling them to acquire better control over their Forex risk and be more confident in their international transactions.

  4. Finally, in an uncertain scenario, Deaglo can be a strong partner in organizing and presenting the facts in a clear and simple manner, which can help to accelerate decision-making by removing emotion from the equation.

If you're a GP who is struggling with currency exposure in your foreign investments or deals,

Alternatively, if you want to get hands-on experience with our investment platform, join the waitlist here.

Else, here is a case study of one of our clients who implemented a tailored Forex hedging strategy to protect its portfolio of LATAM assets.

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