foreign exchange risk management solutions

www.ninemileco.com 1.800.873.9118Plan SolveGrow

NINE MILEM a n a g e m e n t C o n s u l t i n g

Copyright © 2012. All Rights Reserved. The Nine Mile Management Consulting Group

Foreign ExchangeRisk Management Solutions Elliott, G., Elliott, A. & Brar, H.

Plan. Solve. Grow.

Foreign Exchange Risk Management

The Foreign Exchange (FOREX) market is a market in which participants buy, sell, exchange and speculate on currencies. Participants include banks, businesses, investment management firms, hedge funds, and retail FOREX brokers. In Canada, 87% of the SME (Small-to-Medium Enterprise Business) market either imports or exports, which clearly illustrates Canada's strong dependence on foreign trade activity. Currency markets are highly liquid, and therefore volatile or "risky", with exchange rates changing every second. Being characterized by fragility, currency markets are also sensitive to changes in both economic and political data including interest rate fluctuations, balance of trade metrics, as well as GDP information. The average SME in Canada suffers approximately $50,000 to $125,000 in foreign exchange losses annually, which highlights the need for companies to develop risk management strategies that help reduce market related risk exposures.

How the Foreign Exchange Industry Works

The aim of this paper is to demonstrate how implementing an unbiased foreign exchange risk management program can help organizations save thousands of dollars in FX related transaction costs, and effectively streamline trade related settlement processes. Conventionally importers and exporters utilize small broker-age houses to seek out financial advice. However, this is not an effective means to reduce risk and cut costs, since the opinion of a financial institution is almost certainly biased towards their own interests.

Why Receiving Advice from your Broker is Not a Good Idea

Brokers are sales people, not advisors. Granted some brokers do have consulting experience, however, a good majority lack any backing in finance whatsoever, beyond the 1 month crash course their workplace provides during probation. In fact, it's not uncommon for smaller financial institutions to hire individuals with non-quantitative college diplomas to carry out trades, and provide haphazard advice to corporate clients. Before doing business with your broker, ensure that you know their professional, and academic background thoroughly. Just because they claim they're a broker, doesn't mean they have the expertise to ensure that you're receiving sound financial advice.

How do Broker’s Make Money?

Broker's in the FX industry are either paid strictly commission, or they're paid a base salary plus commission. The commission is earned through spreads, or the absolute distance between the client rate, and the market rate. Either way, broker's are driven by greed thanks to monthly, and quarterly gross profit targets established by upper management, which are ever increasing. In order to achieve gross profit targets, broker's have to continually drum up new business through referrals, and cold calls, or they have to increase their spreads on existing clients. To generate new customers, it's customary to offer teaser or under market rates to prospective clients -- once a relationship is established these near market rates, very similar to the bank of Canada posted rates, quickly diminish. The idea is simple and it's a deceptive three step sales one - lower price, build rapport, raise price. There's nothing wrong with this process, just as long as your broker is transparent about it. However, in most cases, they're not, which is why benchmarking your rates to ensure you're getting the best possible price is imperative.

Where is FX Heading?

The industry as a whole is moving towards increased transparency, real-time access to rates, and user-initiated facilitation of trades.

The industry is becoming open with increased clarity.

Future Predictions - Mobile trading - Consolidation of market; only a few large brokers will be left - Availability of more trading platforms - Greater transparency of market rates, real time data - Increased trading volumes


Copyright © 2012. All Rights Reserved. The Nine Mile Management Consulting Group 1

Bigger brokerage houses employ differentiating sales strategies, since their product offerings are broader, and more diversified. In fact, larger houses are often transparent about spot rates, since any number of websites post them live. However, when it comes to talking about derivatives pricing structures, brokers tend to be dismissive, since most companies, and private individuals lack the requisite knowledge to benchmark option and/or swap prices. This lack of knowledge allows banks, and competing FX houses to quote spreads that would be considered unethical by most legal bodies. Granted, profit is a natural part of business, however, fair pricing regimes have to be established to regulate cost injustices, and that's why third party consulting firms are necessary. Not only can we create unbiased hedging strategies that help companies save thousands of dollars in FX related transaction costs, but our company ensures that your trades are carried out at a fair price.

Hedging Products and Measuring Risk

Understanding and having the proper tools to measure risk are all important when establishing a foreign exchange risk management program. However, banks, and smaller brokerages are divergent in both their capability, and focus. Banks, on the one hand, possess the specific tools to measure risk, but aren't interested in servicing the SME market. Whereas, smaller FX firms simply lack the intellectual resources to create sustainable, and effective risk management programs. Their approach is more service driven. Brokers will often call customers when rates move in a "favourable" direction. The establishment of a "favourable" rate, of course, is grounded in a self-serving need to generate profit. Don't be fooled by intellectual jargon, such as, "Fibonacci retracement series" or "Interest rate parity". These terms are utilized to camouflage ignorance, and are all part of a script brokers memo-rize to defend against inquiring minds. Unless traders possess a Masters degree or Doctorate in mathematics, their expertise can be considered suspect, and virtually unreliable. Again, checking credentials is essential.

Hedging, or protecting your bottom-line from systemic risk has less to do with what Fibonacci says, and more to do with building robustness around fragile systems where improbable events can have a huge impact on the performance of your company.

What is Risk and How Can you Protect Yourself Against It?

Risk is a probabilistic phenomena and is defined simply as the probability of experiencing harm or loss. Risk management is concerned with risk minimi-zation. There are several existing, and working theories in risk management that are readily adaptable, and applicable to the foreign exchange market. One such tool, called Value at Risk (VaR), is used quite extensively in financial engineering, and portfolio management to measure the risk of loss on a portfolio of financial assets. It's ability to capture risk as a number, provided the underlying probability distribution and modeling techniques are sound, makes VaR a reliable risk measuring tool. In addition to VaR, banks have created several products that help companies mitigate foreign exchange risk, and they include, variance swaps, futures contracts, and put options to name a few. However, simply utilizing a product is not a strategy. Receiving proper guidance coupled with a clear understanding of how each hedging product works ensures that your company is on the right path to hedging risk, and saving money.

Hedging Products

Forward Contract

A forward contract, as it relates to a foreign exchange transaction, is an agreement between two parties to buy or sell a currency on a fixed date in the future, called the date of delivery. The party selling the currency, typically a bank or a brokerage house, is said to possess a short forward position. The party buying, typically the client, is said to have a long forward position. Forward contracts, in simple terms, are “buy-now-pay-later” products that allow corporate clients to lock in rates for an extended term. Banks allow customers to lock in rates for up to 3 years, and offer zero deposit programs, given that they leverage some form of debt including a mortgage, lease, or line of credit. Brokerage houses, on the other hand, aren't as flexible. They can lock in rates for up to one year, but in general require a 5-10% deposit as leverage, which is reimbursed on the date of delivery. By locking in rates long-term, companies benefit from eliminating all exposure to market risk. In other words, if your company buys soccer balls from the United States with Canadian currency on a daily basis, whether the currency tanks or flourishes is of no concern to you because your price is fixed for the entire term of the contract. This means that companies, in addition to reducing exposure to market volatility, also benefit from locking in profit margins long term.

Options Contract

An options contract is an agreement between two parties to buy or sell a currency on a fixed date in the future. At the onset both parties must agree upon a price, also called the strike generally denoted by the letter "k". The two major differences between options and forwards are as follows: firstly, participants that are long (buyers) can either exercise their right to purchase the underlying asset (currency in this case) or defect on the date of delivery. Defecting usually occurs if the market moves against the buyer. The second key differentiating factor is, long participants must also pay a premium in order to engage, which serves as a form of leverage to the seller in the event that defection occurs. Options are a wonderful product, but can expose sellers to infinite loss risks, and buyers to premium pricing risks. However, with the proper strategy in place options can serve as a beneficial addition to one's currency hedging portfolio. It should be noted that options are speculative in nature, and can expose your company to unwanted risk, especially if you're uncertain as to the nature of the contract. Brokerage firms and banks are known for creating confusing products they call options, specifically barrier option products, that on the surface appear safe, but can be quite dangerous, which is why reading and understanding the contract thoroughly is of critical importance.

Foreign Exchange Case Study

The following case study illustrates the importance of Value at Risk as a risk measure in foreign exchange related business activities. Before continuing, however, the concept of Value at Risk will be presented utilizing a basic example.

Example:

Suppose we purchase a share of stock from Company A that holds the initial value S(0)=$200 (fixed). Suppose also,



that we wish to sell our share after one year. The selling price S(1) is a random variable. What we have is a stochastic process, where S represents the random stock price, which is assumed to be lognormally distributed. The way in which the random variable is distributed is important, but isn't of any immediate concern. What concerns us is our averseness or capacity to take risk. Surely we will incur a loss if S(1) < 200er where r represents the risk free rate under continuous compounding and e represents Euler’s number (~2.718). Which begs the question, what is the probability of incurring a loss less than some arbitrary amount? For example:

P(S(0) - S(1) < $30) = ? is the same as P(Loss < $30) = ?

Now, suppose we fix the probability at 0.90, for arguments sake, and fix our upper bound amount, which we call VaR. This yields:

P(S(0) - S(1) < VaR) = 0.90 or 90%

In simple terms VaR (as above) is the probability of losing a particular amount for a set level of probability, and is used extensively as a measure in banking to manage all types of risk.

Case:

"A company manufactures goods in the UK for sale in the US. The investment to start production is 5 million pounds (GBP). Additional funds can be raised by borrowing British pounds at 16% to finance a hedging strategy - the rate of return demanded by investors bearing in mind the risk involved is 25%. The sales are predicted to generate 8 million dollars at the end of the year. The costs are 3 million pounds per year. The interest rates are 8% for US dollars and 11% for GBP. The current rate of exchange is 1.6 dollars to 1 GBP. The volatility of the logarithmic return on the rate of exchange is estimated at €=15%. The company pays 20% tax on earnings."

Strategy One - Unhedged Position:

"If, at the end of the term, the exchange rate is 1.6USD=1GBP, then net earnings will equal 1.6 million GBP - See Table 1.1 below for a more thorough analysis:"

"The result is 0.35 million GBP. Next, suppose the pound strengthens and the cross currency price becomes 2 USD for every 1 GBP, therefore investors will end up losing 0.45 million GBP as indicated by Table 1.2. “

Table 1.1 Sales $5 Million Costs -$3 Million Earnings Before Tax $2 Million Tax -$0.4 Million Earnings After Tax $1.6 Million Dividend -$1.25 Million Result $0.35 Million or $350,000

Now, suppose we fix the probability at 0.90, for arguments sake, and fix our upper

In simple terms VaR (as above) is the probability of losing a particular amount for a set level of probability, and is used extensively as a measure in banking to manage

"A company manufactures goods in the UK for sale in the US. The investment to start production is 5 million pounds (GBP). Additional funds can be raised by borrowing British pounds at 16% to finance a hedging strategy - the rate of return demanded by investors bearing in mind the risk involved is 25%. The sales are predicted to generate 8 million dollars at the end of the year. The costs are 3 million pounds per year. The interest rates are 8% for US dollars and 11% for GBP. The current rate of exchange is 1.6 dollars to 1 GBP. The volatility of the logarithmic return on the rate

"If, at the end of the term, the exchange rate is 1.6USD=1GBP, then net earnings will



Calculating VaR allows us to determine a maximum rate for varying levels of probability. Selecting a confidence level of 95% tells us that 1 GBP will never exceed 1.9650 USD (we've omitted all formulas to maintain a level of simplic-ity). The resultant VaR, given a 95% confidence level, is approximately 392,968 (maximum loss with probability 0.95). Table 1.3 below clarifies.

The breakeven rate according to the above VaR calculation is approximately 1.7534 USD to 1 GBP. Supposing the pound weakens then places us in a beneficial scenario, with a final balance of approximately 620,000 GBP. This example illustrates how stochastic processes can impact profits. It also illustrates the types of risks businesses face. However, the question really is, now that we know how VaR works, how can we effectively manage our portfolios exposure to risk? Of course, as discussed above, several products including options, and forwards are designed to mitigate such risk. Clearly, remaining un-hedged leaves us in a rather interesting position, since VaR tells us that over a certain time horizon our risk of losing at most 392,000 GBP is 95%. Let's show how hedging can protect us from moving markets.

Strategy Two - Hedging With a Forward Contract:

Clearly the above scenario tells us that it's not advantageous for the GBP to strengthen. Now, suppose we lock in a forward when 1 GBP = 1.5527 USD. This decision results in a guaranteed surplus regardless of what changes occur in the market. However, the buyer loses out on possible gains should the rate improve. In any event, for purchasers of goods abroad, this product serves as a great hedger since participants can benefit from zero exposure to market risk, and assured profit margins. The resultant surplus obtained by applying the above strategy: 471,818 GBP.

The above example outlines the importance of understanding risk, and showcases the benefits of capitalizing on hedging opportunities. Several additional products exist, and can be used in conjunction with forwards to create mixed hedges in an attempt to mitigate systemic risk inherent in the market. Nine Mile Management Consulting can help you design, and implement strategies that will help streamline your FX related inefficiencies. Lean how we can help your company Plan, Solve, and Grow.M. Capinski and T. Zastawniak. Mathematics for Finance: An Introduction to Financial Engineering. London: Springer-Verlag. pp. 200-207.

Table 1.2 Sales $4 Million Costs -$3 Million Earnings Before Tax $1 Million Tax -$0.2 Million Earnings After Tax 0.8 Million Dividend -$1.25 Million Result -$0.45 Million or $350,000

Table 1.3 Sales $4.071 Million Costs -$3.0 Million Earnings Before Tax $1.071 Million Tax -$0.214 Million Earnings After Tax $0.857 Million Dividend -$1.250 Million Result -$392,968


Copyright © 2012. All Rights Reserved. The Nine Mile Management Consulting Group

@ninemileco

linkedin.com/company/nine-mile-consulting

facebook.com/ninemileco

To help your business reach its full potential, please contact us:

1.800.873.9118

[email protected]

Our Consultants bring a range of diverse backgrounds, educations, and industry experiences. We constantly look for ways to solve business problems, seek growth opportunities, and leverage internal capabilities. We are passionate about what we do.

4

foreign exchange risk management solutions

Documents