Managing Volatility In The Foreign Exchange Market

Managing Volatility In The Foreign Exchange Market

03 Jan 2020 04:24 PM

Foreign exchange volatility is what drives the currency market and higher volumes are seen during the high volatile days. In the global foreign exchange market there are unpredictable movements of foreign exchange rates. These movements cause volatility which is not accounted for or predicted and the investors or traders tend to react suddenly to such events or news. Often the reaction triggers stop loss levels drastically moving the currency. Large losses or gains are observed and are the principal cause of forex risk.

Factors affecting FX volatility

Currency volatility must be managed effectively as it is the greatest credit risk for any company which in turn affects the bottom-line of the company. Often volatility is expected around global events or data releases. Recent examples of Brexit, US China trade war, unexpected Monetary Policy decisions, etc. Sometimes global companies like Google, Apple, etc, post losses much against the expectation of analysts and research houses. These result in huge volatility in the currency markets. A foreign exchange strategy needs to be formulated which needs to be robust and helps the corporates protect their profit margins during such volatile times.

Managing FX volatility

Managing volatility in forex market is of importance to ensure foreign exchange is a profit center instead of a cost center. To reduce volatility exposure one needs to

  • Assess risk profile and the risk exposure through quantitative analysis. VaR measures all types of FX risk exposures.
  • Combining all types of FX risk exposures across entities for a risk portfolio makes it important to know how absence of profiling can affect financial results based on currency rate fluctuations.
  • Hedging policy is a must to know the risk-reward and protecting benchmark levels. Outlining goals and process of hedging will be key points for formulating a policy. Reviewing of the policy is a must based on ever changing forex markets.
  • Natural hedging is an efficient tool for managing currency volatility. Residual risk is bound to be there as most corporates are unable to eliminate total exposures through hedging. Corporates often use short-term hedging tools to protect profitability and long-term capital structure hedges to minimize volatility.

Hedging as a tool

Hedging is the key to manage currency volatility and all corporates should have a well planned hedging strategy as incentives from hedging help it from being categorized as a cost center. Often companies tend to aim for higher profits by gambling on a one-way exchange rate movement. An exporter may not hedge his expected foreign currency inflows as he may expect the currency to depreciate may be categorized as being a speculator. Similarly when the currency appreciates, the importer expects higher appreciation and may not hedge his payments will amount to deliberate incomplete hedging.

Cash flows have to be protected at all times keeping in mind the strategy placed but also be ready to accept opportunity losses which may follow post hedging. Sometimes during volatile markets, short term hedging may be more appropriate as cash flows tend to affected. Hedging should be done at minimum cost to meet specific objectives as laid down in forex hedging policy.

Currency hedging strategies

A strategy is formulated to mitigate the impact of foreign exchange risk which occurs in the currency markets. Mainly currency derivatives are used to hedge this risk. Forward contracts, options, swaps are some of the popularly used currency derivatives. Thus these aim at protecting the profit margins of corporates from forex volatility which prevail in the foreign exchange market. It is a vital component of FX risk management tools.

These products derive their value or payoff from foreign exchange rate of currencies.

Forward contract – it is an over the counter transaction and the transaction is completed on an agreed future date. Both the buyer and seller agree to exchange the currency for a future date at a fixed exchange rate which is decided on the specified date of transaction. Then irrespective of where the foreign exchange rates move on the future date, the transaction is abided at the same fixed rate. Since an exchange is not involved, these contracts are not regulated.

Options – this is a derivative wherein the buyer of the option has the right but not the obligation to exchange currency at a pre-determined rate on the specified date. The options involve a premium which is like an insurance premium which is fixed while entering into an option contract. Call and put option help to formulate the hedging strategy.

Swaps – in a forex swap derivative, two parties agree to exchange currencies for a period of time and agree to reverse the same at a later specified date. Since these derivatives are also not transacted through an exchange, they are non-standardized contracts.

Futures – these are traded on an exchange and thus standardized. For a particular volume, a currency is exchanged for a settlement date. But to minimize the credit risk, these are daily settled. Leveraging on the future contracts make them riskier than other derivative products.

Can one really prepare for forex volatility?

Managing forex volatility required time to analyze and understand the nuances of the largest financial market and the same is left to the finance vertical which may not always have forex experts who can advise on the corporate forex portfolio. Thus often, forex risk advisory is outsourced to well experienced advisors who have state of the art dealing room and assist in processing the forex deals while negotiating the rates with the banks. Banks are not very transparent in their margins and rates which are prevailing in the foreign exchange markets. Thus deploying forex expert team which watches the currency market and formulates hedging strategies which are customized as per the needs helps in protecting the benchmark or costing.

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