Managing risk in foreign exchange trading

The foreign exchange business is by its nature risky, because it deals primarily in risk—measuring it, pricing it, accepting it when appropriate, and managing it. The success of a bank or other institution trading in the foreign exchange market depends critically on how well it assesses, prices, and manages risk, and on its ability to limit losses from particular transactions and to keep its overall exposure controlled.

Broadly speaking, the risks in trading foreign exchange are the same as those in marketing other financial products. These risks can be categorized and subdivided in any number of ways, depending on the particular focus desired and the degree of detail sought. Here, the focus is on two of the basic categories  of risk—market risk and credit risk (including settlement risk and sovereign risk) as they apply to foreign exchange trading.Note is also taken of some other important risks in foreign exchange trading—liquidity risk, legal risk, and operational risk.

There are many ways to measure foreign exchange risk, ranging from simple to quite complex. Sophisticated measures such as ‘value at risk’ may be mathematically complex and require significant computing power. This guide provides some examples of the simpler measures which can be applied and understood by most businesses.

Register of foreign currency exposures

A very simple method is to maintain a register of exposures and their associated foreign exchange hedges. Basically the details of each hedge are recorded against its relevant exposure.

Table of projected foreign currency cashflows

Where the business both pays and receives foreign currency, it will be necessary to measure the net surplus or deficit for each currency. This can be done by projecting foreign currency cash flows. This not only indicates whether the business has a surplus or is short of a particular currency, but also the timing of currency flows.

Sensitivity analysis

A further extension of the previous measure is to undertake sensitivity analysis to measure the potential impact on the business of an adverse movement in exchange rates. This may be done by choosing arbitrary movements in exchange rates or by basing exchange rate movements on past history. For example, the business may wish to know how much it will gain or lose for a given change in exchange rates. Where commodities are involved, businesses sometimes develop a matrix showing the combined result of currency and commodity price movements.

Value at risk

Some businesses, particularly financial institutions, use a probability approach when undertaking sensitivity analysis. This is known as ‘value at risk’. While it is useful to know the potential impact of a given change in exchange rates (say a USD one cent movement) the question will arise: how often does this happen? Accordingly, we can do a sensitivity analysis using past price history and apply it to the current position. Then, given the business’s current position, and based on exchange rates observed over the last two years, it can be 99 per cent confident that it will not lose more than a certain amount, given a certain movement in exchange rates. In effect, the business has used actual rate history to model the potential impact of exchange rate movements on its foreign currency exposures.

Intro to Forex

In a universe with a single currency, there would be no foreign exchange market, no foreign exchange rates, no foreign exchange. But in our world of mainly national currencies, the foreign exchange market plays the indispensable role of providing the essential machinery for making payments across borders, transferring funds and purchasing power from one currency to another, and determining that singularly important price, the exchange rate. Over the past twenty-five years, the way the market has performed those tasks has changed enormously.

Forex and You

Forex can affect the lives of everyone, regardless if you don’t travel overseas or don’t invest in currency. Today’s world of commerce is such an international one that happenings on the other side of the world can ripple out to all nations.

China is a perfect example of this. The government in China regulates the exchange rate of their currency, and many believe the currency to be undervalued. A undervalued currency means Chinese made goods can be purchased for “less” on the international market. Were the Chinese government to allow the market to dictate the exchange rate the effects would definitely be felt across the globe, even for Americans who’ve never left America.

The reasons why an individual – or institution – would want to exchange money range to a myriad of different reasons, but the 3 main demographics include large corporations and institutions, speculators (investors) and tourists.

Tourists

A tourist traveling from the United States to England, for example, will need the local currency (Great British Pounds), as common shops, taxi cabs, etc. will most likely not accept US Dollars. Typically the airport, hotels and other tourist destinations will have services to exchange just about any currency into the local tender.

Large Corporations and Institutions

A large portion the global foreign exchange market consists of corporations and institutions, who often exchange currency for non-investment purposes: the need to meet payroll in other countries, to pay for services from a foreign factory, mergers and acquisitions, etc.

Investors

Investors are attracted to the forex market because of its possibilities and advantages (which will be discussed in more detail in the 3rd email of this series). For example, investors enjoy the added liquidity and volume forex has to offer.

Unlike other financial markets, the Forex market operates 24 hours a day, 5.5 days a week (6:00 PM EST on Sunday until 4:00 PM EST on Friday). Through an electronic network of banks, corporations and individual traders exchange currencies, Forex trading begins every day in Sydney, moves to Tokyo, followed by Europe and finally the Americas – making the market available 24 hours during the week.

Forex Market Hours

Unlike other financial markets, the Forex market operates 24 hours a day, 5.5 days a week (6:00 PM ET on Sunday until 4:00 PM ET on Friday). It is conducted through an electronic network of banks, corporations and individual traders exchanging currencies. For retail traders Forex is primarily used as a means for speculative investing and actual physical delivery of currencies is almost never intended. Forex trading begins every day in Sydney, moves to Tokyo, followed by Europe and finally the Americas.