It's Time to Update Your FX Risk Model
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Risk Ticking It’sDollar time to update your FX risk model Larry R. Kirschner Companies need to identify FX exposure before they can determine their hedging policy. Currency pairing is one strategy to consider, but beware of the risks. 28 I AFP Exchange April 2009 lobal companies no longer Admittedly, few models predicted the volatility that occurred use carbon paper or depend in the markets during 2008. However, on the Commodore 64 for accurately predicted the flawed as it may be, the market still offers record-keeping, yet some volatility that occurred in the best yardstick for measuring risk. Gare still assessing foreign exchange risk A typical hedging policy may dictate through antiquated models. Updating the markets during 2008. that a company hedge all FX-related your FX risk procedure takes a few simple risk in excess of $10 million. The spirit steps: analyze risk, understand exposures However, flawed as it may be, of this decision may be to protect the and determine tolerance. the market still offers the best company from losses in excess of $1 Historically, FX risk has been million (using an assessment of risk identified by measuring the total value of yardstick for measuring risk. such as 10% of $10 million). A better international exposure and determining approach is simply to hedge all risk over hedging strategies and policies $1 million. Risk factors can then be accordingly. Some company policies may The currency market prices and applied to various currency pairs and also cast a casual glance at the currency trades on predictions of future currency tenors or time horizons that will identify pair and tenor and, commonly, there is fluctuation. As this article is being written, what exposures should be hedged to language that requires hedging action the market is pricing the notion that this protect $1 million risk. when exposures breach preset amounts. currency pair, the U.S. dollar and the Since the market is valuing the risk These policies can mandate a treasury Canadian dollar, could fluctuate by as factor for the Hong Kong dollar so low, group to hedge unless the exposure exists much as 18% over the next 30 days. This a risk-adjusted threshold of $1 million in a stable currency pair. It is thought means that the market feels that a $10 allows the Hong Kong dollar position to that in stable currency pairs, such as the million USD/CAD exposure could gain grow to $200 million before hedging is Hong Kong dollar vs. the U.S. dollar or or lose as much as $1.8 million 30 days required. Regardless of whether 30-day the Canadian dollar vs. the U.S. dollar, from today. Using the same risk models, risk is created from $10 million exposure exchange rate fluctuations may not be the market is similarly confident that the in Canadian dollars or from $200 materially volatile against each other. Hong Kong dollar will not fluctuate more million exposure in Hong Kong dollars, While well intentioned, these guidelines than .50% against the U.S. dollar over a the market currently assesses both risks may be erroneous. Rather than directing similar 30-day period. Thus, a $10 million to be similarly valued at $1 million. a company’s hedging focus on absolute 30-day exposure could translate into a While there are many black boxes to numbers, attention should be given to $50,000 risk if it is denominated in U.S. assess risk, looking at how volatility is the amount of risk associated with each vs. Hong Kong dollars, compared to $1.8 actually trading in the market is a fairly individual FX exposure. million if it is denominated in U.S. dollars straightforward proposition. It is true that certain currency pairs vs. the Canadian dollar. Clearly, the market Let’s assume the market is currently are at times relatively stable against each realizes that the Canadian dollar vs. the valuing 30-day risk for the U.S. dollar at other; it is also true that a $10 million U.S. dollar is a significantly more volatile 50% vs. the Hong Kong dollar, and 10% exposure for 30 days between the U.S. currency pair than the Hong Kong dollar vs. the Canadian dollar. Exposures less dollar and Hong Kong dollar does not vs. the U.S. dollar. than these amounts would be deemed share the same risk profile as a $10 This type of data has valuable acceptable and remain unhedged. Our million exposure for 30 days between implications for a company’s hedging risk tolerance of $1 million would be the U.S. dollar and the Canadian dollar. policy. Rather than addressing exposure applied to these volatility factors to There is a relatively high possibility at a notional level or total value of determine what exposure would need to that a $10 million exposure between currency exposure, companies can focus be hedged. The internal risk tolerance of the U.S. dollar and the Canadian dollar on how the market is assessing overall $1 million divided by a market-driven will fluctuate by more than 3% or 4% risk. Exposure can be identified as an volatility factor of .50% for the Hong over a 30-day period. Conversely, the absolute number, and risk boiled down Kong dollar equals $200 million in market feels that the relationship of the to a gain or loss associated with the exposure. The same calculation applied U.S. dollar to the Hong Kong dollar will volatility of the underlying exposure. to Canadian dollars equals exposure of hardly vary over the next 30 days. Admittedly, few models accurately $10 million. Our $1 million risk policy www.AFPonline.org AFP Exchange I 29 Risk would dictate that 30-day exposure An internal tolerance for on offsetting risk. Companies need to also greater than $200 million vs. the Hong consider acceptable levels of counterparty Kong dollar or $10 million vs. the risk should be established. risk. A hedge may be rendered useless if Canadian dollar be hedged. Companies Because each company is the counterparty is not able to honor its can turn to their financial partners for side of a commitment. Appropriate levels help in understanding what volatility unique, there is no perfect of internal management oversights and or risk factors they want to use in their formula for determining just approvals should not be overlooked. internal analysis. While no model is how much risk a particular Prudent risk management should infallible, most financial institutions can be thought of as a journey rather than provide a solid methodology for how the culture can tolerate. a pre-packaged trip. Once a process is market is currently valuing or assessing established, results should be reviewed FX risk. and scrutinized. Although it would be One of the first steps in building this forecasted exposures, and others choose unwise to modify investment actions type of model is for a company to get a to only address booked or known risks. to suit the strategy of the day, periodic handle on how FX exposure is created. In Consistency is more important than assessment and modifications should be order to perform a complete assessment, the approach taken; the most successful considered and implemented data need to be collected throughout an hedging plans employ a consistent and Modernizing your FX risk organization. As exposures are identified, thoughtful approach. management model takes a few simple companies should look at ways to net There are commonly two primary steps. Start by identifying risk priorities offsetting currency positions internally. In goals in risk management. First, a strategy and understanding all currency-related many instances, Canadian dollar payables should enable a company to realize exposures. From there, carve out and Canadian dollar receivables can be more predictable and stable financial the netting opportunities and assign at least partially offset internally. For performance. Removing or reducing potential risk levels to the remaining the most part, the timing of payments currency impacts from the equation exposures, taking into account both and receipts is secondary to a high-level eliminates a key variable. The second goal currency pairs and tenor. Look to your understanding of the net exposures. The is to ensure that no FX-related shocks company’s risk tolerance philosophy or market has developed many tools to help occur. When a company has an unexpected policy to decide which risks should be companies finance timing mismatches of gain from a currency movement, there hedged. Once hedging plans are firmly in payables and receivables. may be an expectation for that gain to be place, periodically review and revise plans Once a company has developed tools repeated or even increased in subsequent as necessary. Be careful not to use the to identify net FX exposure, it can begin periods. Conversely, there is no joy when same guidelines today that were put in the process of deciding what to hedge. As there is an unexpected loss. Either scenario place when the company may have had a outlined earlier, an internal tolerance for could result in negative consequences or materially different profile. risk should be established. Because each unachievable expectations. Prudent treasury With a little time, effort and dedication, company is unique, there is no perfect groups simply try to offset FX risk and any company can develop an up-to-date, formula for determining just how much focus outcomes on core business results. comprehensive FX risk management risk a particular culture can tolerate. Details such as who is authorized to strategy. It is time to put away the carbon After going through the exercise enter into hedging transactions, what will paper and the Commodore 64.