Forex Queries

The next stage is to analyze the information gathered. Here is where you incorporate the information regarding the operations, transactions, and corporate objectives with an analysis of the currencies in which the company operates. You identify the risk, in dollar amount, and report the results, along with suitable recommendations. The procedure used to determine risk in each category of exposure is fairly straight forward. First, identify the currencies that denominate exposed positions. Next, measure the exposure in dollar value. Then, measure the degree of foreign currency volatility that can be expected. (This refers to the volatility of nominal exchange rates. Changes in real exchange rates that produce operating exposure require an examination of comparative economic and political conditions-a task for the fundamental research department.)  

Value at Risk  

Obviously, there is no way to determine whether any given exposed position will generate a profit, a loss, or just remain at its current dollar value. You can, however, assign probabilities of value change. There are several analytical tools for finding such probabilities. Value at Risk, or VAR is one tool growing in popularity. Used primarily for institutional investment portfolios, it can be easily adapted to exchange rate volatility.  

VAR is quantified by a measurement of standard deviations. A standard deviation, by definition, is the “dispersion of observations from the mean observation.” In other words, unless a currency price is immobilized at a fixed point (the mean observation), it can be expected to move back and forth from that point. By convention, the point used is the previous market close. A unit of standard deviation equals the expected variance, or price range, from each previous close over a given amount of time.  

As an example, assume that during the last two years, the British pound moved back and forth from the previous close to the next day’s opening about two cents, on an average, every trading day; therefore, a two-cent move in either direction is the overnight volatility of the British pound .We also know that, every so often, the pound makes sudden large overnight moves of four cents or more. What is the probability that the pound will move more than four cents in one direction between tonight’s close and tomorrow’s opening?  

To determine this, assume that the movements are completely random with regard to direction. Plotting the distance of the price move from one trading day to the next, all of the chart points should fall within the area under a bell curve. Because the expected change of value can be expressed as the standard deviation of this curve, one standard deviation is equal to two cents from the close of the previous day. By definition, approximately 95% of the area under a bell curve is contained within two standard deviations; therefore, there is no more than a 5% chance that an overnight move will exceed four cents in either direction from the previous close. Within these parameters, four cents is the maximum value at risk. In other words, our VAR is (no more than) four cents based on a 95% confidence interval, when analyzed with a two year period of historical market data and assuming a normal distribution curve.  

Of course, when assigning risk values to exposed positions, the previous close can be defined on a monthly, quarterly, or even annual bar chart. The expected variance from one quarter to the next would be quite different from the expected variance from one day to the next. After determining the U.S. dollar value of the foreign currency position and the expected variance, or standard deviation, for a given duration, you will know the change of value that probably will occur in the exposed position over time.  

This works well for transaction exposures with finite values and durations. It can also be used for ongoing cash flow exposure. For cash flow, however, an exposure duration must be chosen, such as monthly exposure, quarterly exposure, semi-annual exposure, and so forth.