The 1 day FX Risk Management Strategy
Updated: Apr 13
Hindsight is 20/20 - ironically 2020 is set to be the most volatile year since 2008. Markets are red across the board and the world is on lockdown.
DON'T PANIC - in times of uncertainty, it is important to remember that you can only control what you can control.
Understanding why we are here…
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. 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.
Equity and FX markets have reacted with ferocity, shifting to “risk-off” mode within the last few weeks. Equities are down (officially bear markets, -20%, in many exchanges), gold is up. In the FX markets, JPY, CHF and to a lesser extent USD are rising against all other currencies as investors unwind their carry trades in higher-yielding bonds and riskier equities to fly to safety.
What does it mean to me?
The first step in managing 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 is this calculated? Assuming that market returns are normally distributed, you can use the volatility of the historical market returns to calculate your VaR. Using Excel, populate a column with daily historical spot values. 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 risk, what’s important to me?
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 which 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.
Instruments include forwards, futures, options, long-term debt instruments and cross currency swaps. Each has advantages and disadvantages, and the choice depends on both the firm's risk profile and margins.
Forwards are the most common hedging instrument. They lock in an exchange rate in the future, 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.
Options are another alternative. At the expense of a premium, they protect the downside whilst allowing participation in upside. Pricing is opaque and expensive; they may be a good alternative for firms with a high profit margins and therefore have higher risk tolerance.
The number, size and tenor of the instruments used is 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 which can reduce the cost of hedging while preserving its efficacy.
How much will it cost me?
How long is a piece of string? How much it “costs” depends on a great many factors. Using forwards when both currencies are major (eg GBP, USD, EUR, CAD, AUD, NZD, CHF) is essentially free. Forward points are 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.
Not managing FX risk, is speculation, pure and simple. Hope is not a strategy, and betting the firm 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.
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.
If it matters to you it matters to us - we empower you and your finance teams, so you can focus on your core business strategy.