Description
When a foreign customer or distributor is invoiced in their home currency, and there is any delay between contract and payment (e.g. net 60 terms). • Present in all common forms of payment: Letters of Credit, Documentary Collection or Open Accounts (except cash in advance).
Currency Risk Management, LLC
R$
K?
S/.
kr
R
???
?
$
Q
kr
Foreign Exchange
Risk Management
A primer on protecting and increasing profits
In international transactions and investments
Currency Risk Management, LLC
• The Problem:
• FX Risk
• Currency Volatility
• The Solution:
• Hedging concepts and tools
• Success stories
• Range of hedging solutions
• Implementing the Solution
• Banking
• Getting Started
• Conclusions
Currency Risk Management, LLC
FX Risk
Contracted Spot
Payment spot
Case1: If Exporter bills in EUR, you get a 11% windfall profit.
If Exporter bills in USD, EU importer pays 11% less
Payment spot
Contracted Spot
Case2: If Exporter bills in EUR, you see a 8% loss.
If Exporter bills in USD, EU importer pays 8% more
EUR/USD
Volatility = 13%
There’s always FX risk in an international transaction
Currency Risk Management, LLC
FX Risk
The best option is to assume the FX risk, and then actively manage it.
Transactional risk
• When a foreign customer or distributor is invoiced in their home currency, and
there is any delay between contract and payment (e.g. net 60 terms).
• Present in all common forms of payment: Letters of Credit, Documentary
Collection or Open Accounts (except cash in advance)
• FX exchange rate changes will increase or decrease the price paid or received.
Operational risk (hidden)
• Occurs when companies invoice foreign customers (or distributors) in their home
currency (e.g. a US company invoicing in USD)
• Customers forced to manage FX risk will negotiate less-favorable terms to you.
Studies have shown the negative impact ranges from 3-8%
1
• Clients will seek out more trade-friendly partners.
• Foreign transmittals of USD take longer
http://www.treasuryandrisk.com/2012/02/01/paying-suppliers-in-rmb
Currency Risk Management, LLC
Currency Volatility
“Once every 100 years” events dramatically affected exchange rates
• 1998 Asian Tiger meltdown
• 1998 Russian devaluation and default, LTCM bailout
• 2001 September 11
• 2008 Icesave bank failure
• 2008 Lehman Bros/AIG
• 2010 Greek bailout #1
• 2010 Ireland bailout (and subsequent rejection)
• 2011 Japan tsunami/nuclear reactor disaster, PIIGS debt , US credit de-rating
• 2012 Greek Euro exit? (and waiting on War: Iran/Israel, Syria; Debt crisis: Portugal/Spain
EUR/USD
3 month volatility: 13%
The risk even in “normal” times is
significant
Currency Risk Management, LLC
Responses to FX risk
• Ignore it
– Assume Purchasing Price Parity (PPP)
drives exchange-rate equilibrium,
– Assume F/X rates will “even out” over
time
• Force the other party to take direct
FX risk
• Add a reserve or buffer
– hope it is sufficient
– hope it doesn’t kill the deal
• Actively manage FX risk
– 72% of companies hedge FX risk
1
1.0 AFP 2010 survey of CFOs
Currency Risk Management, LLC
Seek out opportunities to create offsetting exposures
Internal Parties
Subsidiaries JVs
• Foreign
Currency
Dividends
• Royalties
• Service Fees
(inbound)
External Parties
Clients Vendors Banks
• Foreign
Currency
Receivables
• Export Sales
• Foreign
Currency
Payables
• Purchase
Commitments
• Foreign currency
interest and
principle payments
• Foreign Currency
Interest Income
Offsetting needs to be within same relevant time
and within each foreign currency.
But there will always be a net exposure remaining…
Natural Hedging
Currency Risk Management, LLC
Impact on A/R
+
-
Exchange Rate (foreign/home)
A/R Value vs. Exchange Rate
Hedge Value vs. Exchange Rate
A perfect hedge moves exactly opposite to the A/R value,
offsetting any changes in A/R value.
Hedging does NOT require future spot prediction or trend
analysis
Active Hedging
Hedge (h?j)
A security transaction that reduces the risk on an already existing transaction.
Currency Risk Management, LLC
• A Forward is a contract to buy or sell an asset (such as a currency) at a certain price (the
forward rate), on a certain date. It is made between the hedger and a counterparty,
typically a large bank (and thus is over-the-counter, “OTC”).
• The forward rate cannot be at today’s spot, but is offset by forward points (see appendix).
• Forwards are settled at the end of the contract period
Spot
Payoff
Spot
Payoff
Sell Position Buy Position
Forward Rate
Hedging with forwards
Currency Risk Management, LLC
Long Call
Spot
Long Put
Short Put
Short Call
Spot
Spot Spot
Optimally, a hedge allows participation in upside if the spot moves in your favor,
and still protects you on the downside. Options can do that.
Options are the right to buy (Call) or sell (Put) an asset at a certain price (strike),
for a certain duration. The cost (premium) depends on those factors.
Payoff Payoff
Directional hedges with options
Currency Risk Management, LLC
Hedging with One Option
Long
Underlying
Exposure
Spot
Spot
Spot
Long Put
+
Strike
Break even
premium
=
• No collateral or FX LoC required
• Combinations (Puts, Calls, long/short)
allow upside or neutral position with
spot
• Best for hedging forecast cash flows
(uncertainty of exposure)
• Premium more expensive than
forwards, paid upfront
• Long durations are expensive
• If volatility of underlying is high,
premiums are expensive
Advantages Disadvantages
Currency Risk Management, LLC
Success story
NGT secured a sales contract in March 2011 with an EU customer for
$469,708, or €343,028 (EUR/USD 1.369)
A series of four performance payments were scheduled from April
through Nov: design approval, major components, factory acceptance,
and site acceptance.
The first two payments were hedged with Puts at 1.42
The second two hedged with forwards (due to long
duration)
As the EUR fell throughout 2011, NGT’s hedges
saved over $47,000
EUR/USD
Currency Risk Management, LLC
Success story
SM sells sporting goods into Canada, collecting monthly payments
from their distributors.
SM wanted to not only preserve their margin, but use hedging to add
to the bottom line. SM and CRM jointly decide to hedge 80% of
monthly receivables with forwards, and use a profit-generating multi-
option strategy for the remaining 20%
CRM’s option-based hedge
structure added 3% non-
operating revenue at
inception, and retained that
profit throughout the term of
the hedge.
USD/CAD
(P&L in red)
Currency Risk Management, LLC
Success story
US-based FE (a Connecticut-based hedge fund) invests in Brazil.
Their exposure is $2M every quarter, with a Value-at-Risk of $358k.
Hedging USD/BRL is challenging for two reasons:
• Brazilian interest rates are very high, making forwards very expensive
(160 bps/qtr)
• USD/BRL volatility is very high, increasing the cost of options. In
addition, the skew between Calls and Puts is very high.
CRM’s multiple option-based
hedge created a “synthetic”
forward, but cost only 84 bps
As the USD/BRL rose from 1.8
to 1.93, the synthetic forward
saved FE $144,000
USD/BRL
Currency Risk Management, LLC
Flexibility and ease of hedging solutions
• Almost any exposure
• From just one contract to a series of monthly payments
• Certain (contract) or uncertain (forecast) cash flows
• From very short (one week) to very long (5 years) duration
• Almost any currency
• Hedges can be designed to simply eliminate risk
or designed to allow some participation in currency upside
• “Fire and forget”: once your hedge is in place (5 min phone call to
bank), you can focus on your core business and not worry about
exchange rates
Currency Risk Management, LLC
Working with Banks…
• Banks are essential partners in international trade.
• They provide multi-currency accounts, ACH, EFT, Lockboxes, foreign wires
• They provide the hedging instruments we need…however-
• However - pricing of forwards, options, swaps etc. is opaque
• Forward points - a 20 bps misquote of interbank rates could double your hedge cost.
• Option premiums - a 5% difference in implied volatility could increase premiums 50%
• Spot rate quotes from the bank may be delayed or skewed
• Setting expectations…
• Bank bid-ask spread is 20-50 bps over interbank/market pricing. Shop carefully
• They expect you to know what you’re doing, what you want, and how to accurately specify
products based on your exposure
• What they may suggest optimizes their profit and risk, not yours…
• Best to have expert third-party assistance
• Selection of optimum hedge components and specification (notional, strike, tenor, expiry)
• Access to interbank data for price verification
• Assistance with hedge inception documentation and accounting
Currency Risk Management, LLC
Working with CRM
• We eliminate your FX risk, taking the worry out of international transactions.
• All we need from you is cash flow information (amount, dates), and we take
care of the complexities. Your sales & finance staff remain focused on their job
• We can match specific or forecast exposures, almost any currency, any
duration.
• CRM’s inside access to inter-bank pricing helps us negotiate the lowest
premiums and tightest spreads for you. Our own fees are very small (0.25% to
0.5%)
• This is our specialty. The CRM team has over 25 years of FX experience. We
are happy to share anonymized deal histories and client referrals
• No Conflict of Interest - we are consultants only - we do not access your
brokerage account, and we do not earn any fees from banks or market-makers
Currency Risk Management, LLC
Getting Started
• Establish relationships
• A banking relationship which provides the FX instruments (forwards,
options). It’s best if this is an existing account, as business deposits can
count towards any margin required. If a new account is needed, be
advised banking “Know Your Customer (KYC), and “Anti Money
Laundering” (AML) processes can take several weeks
• Execute the Currency Risk Management consulting agreement. This 3-
page agreement doesn’t carry any obligation or expense, it only
establishes our business relationship
• Operational Phase
• Client confirms cash flows and timing to CRM, and orders hedge
• CRM designs a hedge structure for each unique cash flow/transaction
• Joint Client/bank calls to initiate hedges
• CRM reports interim results, assists in any necessary changes
Currency Risk Management, LLC
Conclusions
• Any exporter or importer will have unavoidable and significant FX risk in its
international transactions
• FX risk is easily mitigated (with the right expertise)
• As a guideline, the all-in cost
1
is approximately 1% of contract value for G-7
currencies (easily built in to your contracts). This much, much less than the
average Value-at-Risk of 12-15%.
• It costs nothing, but takes time to get ready to hedge your international
transactions. Start now!
1. FX derivatives, bank spread and CRM fees
Currency Risk Management, LLC
Appendix
Currency Risk Management, LLC
Using forwards
Forwards are best suited to:
• Certain exposures – i.e. contractual exposures, not forecast cash flows.
• Long duration hedges
• Currencies with low interest rate differentials
The expiry date can be easily (and inexpensively) extended if a
customer payment is delayed
Forwards sometimes require margin or collateral, and in general do
not allow upside.
Forwards are available in more complex flavors (e.g. participating
forwards, accumulator forwards, knock-in forwards)
Currency Risk Management, LLC
Determining the forward rate
FX Bank Exporter
EUR/USD Spot rate 1.3140
USD 6 mo interest rate 0.955%,
EUR 6 mo interest rate 0.714%
Today, $1,000 = €769
In 6 months,
€769 invested at 0.714% = €774.50
$1,000 invested at 0.955% = $1,009.5
Gives a Forward rate of 1009.5/774.5 = 1.3034
$1,000
Far date
(6 months)
€767
If the forward rate was the same as today’s spot, an arbitrageur could make a riskless profit
Near date
Fwd
contract
For EUR, GBP, CAD, JPY, the rate is very similar to the spot.
For currencies with high interest rate differentials (BRL, AUD), the rate will vary more
Currency Risk Management, LLC
Value at Risk (VaR)
Mean
1 Std Dev = 68.3%
2 Std Dev = 95.4%
3 Std Dev = 99.7%
Value at Risk then is the potential loss, with a certain level of
confidence, e.g. 90%, 95%, 99%.
Let’s calculate VaR for a $1M contract with volatility of 13%,
to a 90% confidence. 90% is 1.28 standard deviations (the
“z-value”, in statistical terms)
90% VaR = 1.28*Std Dev*contract value
90% VaR = 1.28*13%*$1M = $166,400
This is not a maximum loss. We used a 90% confidence
level. 10% of the time, it could be more...
Spot
A standard measure of potential loss, VaR assumes that spot prices vary
randomly about a mean, with a normal distribution. That is, smaller price
changes are more common than larger ones.
Currency Risk Management, LLC
Case Study #1 – $1M USD hedged with forward
• EUR/USD spot 1.3140
• $1M = € 769,000 at inception
• 3 month volatility 11%
• Value-at-Risk = $140,800 (14%)
Hedge
• Forward Contract to
sell €769,000 in 3
months
• Forward points
.00069 (.07%)
• Resulting forward
rate 1.31469
End result – P&L indifferent to spot changes
Currency Risk Management, LLC
Case Study #2 – $1M EU sale hedged with long
option
Spot 1.314, volatility 11%
3 month EUR Put option, strike 1.3,
Premium 1.7%, break-even spot 1.278
Currency Risk Management, LLC
Case Study #3 – Hybrid hedges
Two options, one bought, one sold, different strikes and notionals
Net 4% premium to hedger, break-even spot 1.23
Currency Risk Management, LLC
CRM Fee
The first transactional consulting fee is 0.5% of the notional or face amount of
each individual exposure hedged, with a minimum notional of $50,000
The consulting fee is discounted as the aggregated sum of all previous hedge
notionals exceeds levels according to the following schedule:
Aggregated notional Fee
Above $1,000,000 0.45% (45 bps)
Above $5,000,000 0.40% (40 bps)
Above $10,000,000 0.35% (35 bps)
Considering random FX movement of 50-100 bps/day,
mitigation of 10-15% Value-at-Risk,
and potential savings in bank bid-ask spreads, CRM easily pays for itself.
doc_883564628.pdf
When a foreign customer or distributor is invoiced in their home currency, and there is any delay between contract and payment (e.g. net 60 terms). • Present in all common forms of payment: Letters of Credit, Documentary Collection or Open Accounts (except cash in advance).
Currency Risk Management, LLC
R$
K?
S/.
kr
R
???
?
$
Q
kr
Foreign Exchange
Risk Management
A primer on protecting and increasing profits
In international transactions and investments
Currency Risk Management, LLC
• The Problem:
• FX Risk
• Currency Volatility
• The Solution:
• Hedging concepts and tools
• Success stories
• Range of hedging solutions
• Implementing the Solution
• Banking
• Getting Started
• Conclusions
Currency Risk Management, LLC
FX Risk
Contracted Spot
Payment spot
Case1: If Exporter bills in EUR, you get a 11% windfall profit.
If Exporter bills in USD, EU importer pays 11% less
Payment spot
Contracted Spot
Case2: If Exporter bills in EUR, you see a 8% loss.
If Exporter bills in USD, EU importer pays 8% more
EUR/USD
Volatility = 13%
There’s always FX risk in an international transaction
Currency Risk Management, LLC
FX Risk
The best option is to assume the FX risk, and then actively manage it.
Transactional risk
• When a foreign customer or distributor is invoiced in their home currency, and
there is any delay between contract and payment (e.g. net 60 terms).
• Present in all common forms of payment: Letters of Credit, Documentary
Collection or Open Accounts (except cash in advance)
• FX exchange rate changes will increase or decrease the price paid or received.
Operational risk (hidden)
• Occurs when companies invoice foreign customers (or distributors) in their home
currency (e.g. a US company invoicing in USD)
• Customers forced to manage FX risk will negotiate less-favorable terms to you.
Studies have shown the negative impact ranges from 3-8%
1
• Clients will seek out more trade-friendly partners.
• Foreign transmittals of USD take longer
http://www.treasuryandrisk.com/2012/02/01/paying-suppliers-in-rmb
Currency Risk Management, LLC
Currency Volatility
“Once every 100 years” events dramatically affected exchange rates
• 1998 Asian Tiger meltdown
• 1998 Russian devaluation and default, LTCM bailout
• 2001 September 11
• 2008 Icesave bank failure
• 2008 Lehman Bros/AIG
• 2010 Greek bailout #1
• 2010 Ireland bailout (and subsequent rejection)
• 2011 Japan tsunami/nuclear reactor disaster, PIIGS debt , US credit de-rating
• 2012 Greek Euro exit? (and waiting on War: Iran/Israel, Syria; Debt crisis: Portugal/Spain
EUR/USD
3 month volatility: 13%
The risk even in “normal” times is
significant
Currency Risk Management, LLC
Responses to FX risk
• Ignore it
– Assume Purchasing Price Parity (PPP)
drives exchange-rate equilibrium,
– Assume F/X rates will “even out” over
time
• Force the other party to take direct
FX risk
• Add a reserve or buffer
– hope it is sufficient
– hope it doesn’t kill the deal
• Actively manage FX risk
– 72% of companies hedge FX risk
1
1.0 AFP 2010 survey of CFOs
Currency Risk Management, LLC
Seek out opportunities to create offsetting exposures
Internal Parties
Subsidiaries JVs
• Foreign
Currency
Dividends
• Royalties
• Service Fees
(inbound)
External Parties
Clients Vendors Banks
• Foreign
Currency
Receivables
• Export Sales
• Foreign
Currency
Payables
• Purchase
Commitments
• Foreign currency
interest and
principle payments
• Foreign Currency
Interest Income
Offsetting needs to be within same relevant time
and within each foreign currency.
But there will always be a net exposure remaining…
Natural Hedging
Currency Risk Management, LLC
Impact on A/R
+
-
Exchange Rate (foreign/home)
A/R Value vs. Exchange Rate
Hedge Value vs. Exchange Rate
A perfect hedge moves exactly opposite to the A/R value,
offsetting any changes in A/R value.
Hedging does NOT require future spot prediction or trend
analysis
Active Hedging
Hedge (h?j)
A security transaction that reduces the risk on an already existing transaction.
Currency Risk Management, LLC
• A Forward is a contract to buy or sell an asset (such as a currency) at a certain price (the
forward rate), on a certain date. It is made between the hedger and a counterparty,
typically a large bank (and thus is over-the-counter, “OTC”).
• The forward rate cannot be at today’s spot, but is offset by forward points (see appendix).
• Forwards are settled at the end of the contract period
Spot
Payoff
Spot
Payoff
Sell Position Buy Position
Forward Rate
Hedging with forwards
Currency Risk Management, LLC
Long Call
Spot
Long Put
Short Put
Short Call
Spot
Spot Spot
Optimally, a hedge allows participation in upside if the spot moves in your favor,
and still protects you on the downside. Options can do that.
Options are the right to buy (Call) or sell (Put) an asset at a certain price (strike),
for a certain duration. The cost (premium) depends on those factors.
Payoff Payoff
Directional hedges with options
Currency Risk Management, LLC
Hedging with One Option
Long
Underlying
Exposure
Spot
Spot
Spot
Long Put
+
Strike
Break even
premium
=
• No collateral or FX LoC required
• Combinations (Puts, Calls, long/short)
allow upside or neutral position with
spot
• Best for hedging forecast cash flows
(uncertainty of exposure)
• Premium more expensive than
forwards, paid upfront
• Long durations are expensive
• If volatility of underlying is high,
premiums are expensive
Advantages Disadvantages
Currency Risk Management, LLC
Success story
NGT secured a sales contract in March 2011 with an EU customer for
$469,708, or €343,028 (EUR/USD 1.369)
A series of four performance payments were scheduled from April
through Nov: design approval, major components, factory acceptance,
and site acceptance.
The first two payments were hedged with Puts at 1.42
The second two hedged with forwards (due to long
duration)
As the EUR fell throughout 2011, NGT’s hedges
saved over $47,000
EUR/USD
Currency Risk Management, LLC
Success story
SM sells sporting goods into Canada, collecting monthly payments
from their distributors.
SM wanted to not only preserve their margin, but use hedging to add
to the bottom line. SM and CRM jointly decide to hedge 80% of
monthly receivables with forwards, and use a profit-generating multi-
option strategy for the remaining 20%
CRM’s option-based hedge
structure added 3% non-
operating revenue at
inception, and retained that
profit throughout the term of
the hedge.
USD/CAD
(P&L in red)
Currency Risk Management, LLC
Success story
US-based FE (a Connecticut-based hedge fund) invests in Brazil.
Their exposure is $2M every quarter, with a Value-at-Risk of $358k.
Hedging USD/BRL is challenging for two reasons:
• Brazilian interest rates are very high, making forwards very expensive
(160 bps/qtr)
• USD/BRL volatility is very high, increasing the cost of options. In
addition, the skew between Calls and Puts is very high.
CRM’s multiple option-based
hedge created a “synthetic”
forward, but cost only 84 bps
As the USD/BRL rose from 1.8
to 1.93, the synthetic forward
saved FE $144,000
USD/BRL
Currency Risk Management, LLC
Flexibility and ease of hedging solutions
• Almost any exposure
• From just one contract to a series of monthly payments
• Certain (contract) or uncertain (forecast) cash flows
• From very short (one week) to very long (5 years) duration
• Almost any currency
• Hedges can be designed to simply eliminate risk
or designed to allow some participation in currency upside
• “Fire and forget”: once your hedge is in place (5 min phone call to
bank), you can focus on your core business and not worry about
exchange rates
Currency Risk Management, LLC
Working with Banks…
• Banks are essential partners in international trade.
• They provide multi-currency accounts, ACH, EFT, Lockboxes, foreign wires
• They provide the hedging instruments we need…however-
• However - pricing of forwards, options, swaps etc. is opaque
• Forward points - a 20 bps misquote of interbank rates could double your hedge cost.
• Option premiums - a 5% difference in implied volatility could increase premiums 50%
• Spot rate quotes from the bank may be delayed or skewed
• Setting expectations…
• Bank bid-ask spread is 20-50 bps over interbank/market pricing. Shop carefully
• They expect you to know what you’re doing, what you want, and how to accurately specify
products based on your exposure
• What they may suggest optimizes their profit and risk, not yours…
• Best to have expert third-party assistance
• Selection of optimum hedge components and specification (notional, strike, tenor, expiry)
• Access to interbank data for price verification
• Assistance with hedge inception documentation and accounting
Currency Risk Management, LLC
Working with CRM
• We eliminate your FX risk, taking the worry out of international transactions.
• All we need from you is cash flow information (amount, dates), and we take
care of the complexities. Your sales & finance staff remain focused on their job
• We can match specific or forecast exposures, almost any currency, any
duration.
• CRM’s inside access to inter-bank pricing helps us negotiate the lowest
premiums and tightest spreads for you. Our own fees are very small (0.25% to
0.5%)
• This is our specialty. The CRM team has over 25 years of FX experience. We
are happy to share anonymized deal histories and client referrals
• No Conflict of Interest - we are consultants only - we do not access your
brokerage account, and we do not earn any fees from banks or market-makers
Currency Risk Management, LLC
Getting Started
• Establish relationships
• A banking relationship which provides the FX instruments (forwards,
options). It’s best if this is an existing account, as business deposits can
count towards any margin required. If a new account is needed, be
advised banking “Know Your Customer (KYC), and “Anti Money
Laundering” (AML) processes can take several weeks
• Execute the Currency Risk Management consulting agreement. This 3-
page agreement doesn’t carry any obligation or expense, it only
establishes our business relationship
• Operational Phase
• Client confirms cash flows and timing to CRM, and orders hedge
• CRM designs a hedge structure for each unique cash flow/transaction
• Joint Client/bank calls to initiate hedges
• CRM reports interim results, assists in any necessary changes
Currency Risk Management, LLC
Conclusions
• Any exporter or importer will have unavoidable and significant FX risk in its
international transactions
• FX risk is easily mitigated (with the right expertise)
• As a guideline, the all-in cost
1
is approximately 1% of contract value for G-7
currencies (easily built in to your contracts). This much, much less than the
average Value-at-Risk of 12-15%.
• It costs nothing, but takes time to get ready to hedge your international
transactions. Start now!
1. FX derivatives, bank spread and CRM fees
Currency Risk Management, LLC
Appendix
Currency Risk Management, LLC
Using forwards
Forwards are best suited to:
• Certain exposures – i.e. contractual exposures, not forecast cash flows.
• Long duration hedges
• Currencies with low interest rate differentials
The expiry date can be easily (and inexpensively) extended if a
customer payment is delayed
Forwards sometimes require margin or collateral, and in general do
not allow upside.
Forwards are available in more complex flavors (e.g. participating
forwards, accumulator forwards, knock-in forwards)
Currency Risk Management, LLC
Determining the forward rate
FX Bank Exporter
EUR/USD Spot rate 1.3140
USD 6 mo interest rate 0.955%,
EUR 6 mo interest rate 0.714%
Today, $1,000 = €769
In 6 months,
€769 invested at 0.714% = €774.50
$1,000 invested at 0.955% = $1,009.5
Gives a Forward rate of 1009.5/774.5 = 1.3034
$1,000
Far date
(6 months)
€767
If the forward rate was the same as today’s spot, an arbitrageur could make a riskless profit
Near date
Fwd
contract
For EUR, GBP, CAD, JPY, the rate is very similar to the spot.
For currencies with high interest rate differentials (BRL, AUD), the rate will vary more
Currency Risk Management, LLC
Value at Risk (VaR)
Mean
1 Std Dev = 68.3%
2 Std Dev = 95.4%
3 Std Dev = 99.7%
Value at Risk then is the potential loss, with a certain level of
confidence, e.g. 90%, 95%, 99%.
Let’s calculate VaR for a $1M contract with volatility of 13%,
to a 90% confidence. 90% is 1.28 standard deviations (the
“z-value”, in statistical terms)
90% VaR = 1.28*Std Dev*contract value
90% VaR = 1.28*13%*$1M = $166,400
This is not a maximum loss. We used a 90% confidence
level. 10% of the time, it could be more...
Spot
A standard measure of potential loss, VaR assumes that spot prices vary
randomly about a mean, with a normal distribution. That is, smaller price
changes are more common than larger ones.
Currency Risk Management, LLC
Case Study #1 – $1M USD hedged with forward
• EUR/USD spot 1.3140
• $1M = € 769,000 at inception
• 3 month volatility 11%
• Value-at-Risk = $140,800 (14%)
Hedge
• Forward Contract to
sell €769,000 in 3
months
• Forward points
.00069 (.07%)
• Resulting forward
rate 1.31469
End result – P&L indifferent to spot changes
Currency Risk Management, LLC
Case Study #2 – $1M EU sale hedged with long
option
Spot 1.314, volatility 11%
3 month EUR Put option, strike 1.3,
Premium 1.7%, break-even spot 1.278
Currency Risk Management, LLC
Case Study #3 – Hybrid hedges
Two options, one bought, one sold, different strikes and notionals
Net 4% premium to hedger, break-even spot 1.23
Currency Risk Management, LLC
CRM Fee
The first transactional consulting fee is 0.5% of the notional or face amount of
each individual exposure hedged, with a minimum notional of $50,000
The consulting fee is discounted as the aggregated sum of all previous hedge
notionals exceeds levels according to the following schedule:
Aggregated notional Fee
Above $1,000,000 0.45% (45 bps)
Above $5,000,000 0.40% (40 bps)
Above $10,000,000 0.35% (35 bps)
Considering random FX movement of 50-100 bps/day,
mitigation of 10-15% Value-at-Risk,
and potential savings in bank bid-ask spreads, CRM easily pays for itself.
doc_883564628.pdf