EXCHANGE RATE RISK

MEASUREMENT AND MANAGEMENT

MEASUREMENT

Measurement of Exchange Rate Risk

Measuring currency risk may prove difficult, at least with regards to translation and economic risk. The VaR methodology can be used to measure a variety of types of risk, helping firms in their risk management Estimate the riskiness of a foreign exchange position resulting from a firms activities, including the foreign exchange position of its treasury, over a certain time period under normal conditions.

Value at Risk (VaR)

VaR is an estimate of the worst possible loss (i.e., the decrease in the market value of a foreign exchange position) an investment could realize over a given time horizon, under normal market conditions (defined by a given level of confidence).

Value-at-Risk calculation
The VaR measure of exchange rate risk is used by firms to estimate the riskiness of a foreign exchange position resulting from a firms activities, including the foreign exchange position of its treasury, over a certain time period under normal conditions (Holton, 2003).

 The holding period, i.e., the length of time over which the foreign exchange position is planned to be held. The typical holding period is 1 day.

 The confidence level at which the estimate is planned to be made. The usual confidence levels are 99 percent and 95 percent.

 The unit of currency to be used for the denomination of the VaR. Assuming a holding period of x days and a confidence level of y%, the VaR measures what will be the maximum loss (i.e., the decrease in the market value of a foreign exchange position) over x days, if the xdays period is not one of the (100-y)% x-days periods that are the worst under normal conditions.

the historical simulation

the historical simulation, which assumes that currency returns on a firms foreign exchange position will have the same distribution as they had in the past;

the variance covariance model

the variance covariance model, which assumes that currency returns on a firms total foreign exchange position are always (jointly) normally distributed and that the change in the value of the foreign exchange position is linearly dependent on all currency returns;

Monte Carlo simulation

Monte Carlo simulation, which assumes that future currency returns will be randomly distributed.

VaR Measurement Techniques

Historical Simulation + Bootstrapping Parametric VaR (also known as Linear VaR, Variance- Covariance VaR and delta-normal approach) Monte Carlo Simulation

Parametric Method
The parametric approach assumes that currency returns on a firms total foreign exchange position are always (jointly) normally distributed (the distribution of returns and thus its probability density function is available) and that the change in the value of the foreign exchange position is linearly dependent on all currency returns.

parameters
The holding period, i.e., the length of time over which the foreign exchange position is planned to be held. The typical holding period is 1 day. The confidence level at which the estimate is planned to be made. The usual confidence levels are 99 percent and 95 percent.

 The unit of currency to be used for the denomination of the VaR. As proposed by the Basle Committee on Banking Supervision, banks are now allowed to calculate capital requirements for their trading books and other involved risks based on a VaR concept (Basle, 1995) and(Basle, 1996) and in Basle committee VaR is recognized as the most comprehensive benchmark for risk measurement.

Types of losses
1) Expected loss: statistical estimate of losses mean. 2) Unexpected loss: maximum loss at a specified tolerance. 3) Extra loss: somewhat higher than the maximum loss with very low probability.

VaR equation

MANAGEMENT

 A firm needs to decide whether to hedge or not these risks. In international finance, the issue of the appropriate strategy to manage (hedge) the different types of exchange rate risk. corporate treasurers have used various currency risk management strategies depending, ceteris paribus, on the prevalence of a certain type of risk and the size of the firm.

TYPES OF HEDGES
Contractual Hedges Natural Hedges

Contractual Hedge
Forward Market Hedge Money Market Hedge Options Market Hedge Futures Market Hedge

Futures and Forward Hedges

A futures hedge uses currency futures, while a forward hedge uses forward contracts, to look in the future exchange rate. Recall that forward contracts are commonly negotiated for large transactions, while the standardized futures contracts tend to be used for smaller amounts.

 To hedge future payables (receivables), a firm may purchase (sell) currency futures, or negotiate a forward contract to purchase (sell) the currency forward. If the forward rate is an accurate predictor of the future spot rate, the real cost of hedging will be zero. If the forward rate is an unbiased predictor of the future spot rate, the real cost of hedging will be zero on average.

Money Market Hedge

The firm may borrow (lend) in foreign currency to hedge its foreign currency receivables (payables), thereby matching its assets and liabilities in the same currency.

Options Market Hedge

A contract that grants the holder the right, but not the obligation, to buy or sell currency at a specified exchange rate during a specified period of time. For this right, a premium is paid to the broker, which will vary depending on the number of contracts purchased. Currency options are one of the best ways for corporations or individuals to hedge against adverse movements in exchange rates.

 Currency options provide a flexible optional hedge against exchange exposure. Generally speaking, the firm may buy a foreign currency call (put) option to hedge its foreign currency payables (receivables), which is known as options market hedge. The firm, however, has to pay for this flexibility in terms of the option premium.