Bigger brokerage houses employ diﬀerentiating sales strategies, since theirproduct oﬀerings are broader, and more diversiﬁed. In fact, larger housesare often transparent about spot rates, since any number of websites post
them live. However, when it comes to talking about derivatives pricingstructures, brokers tend to be dismissive, since most companies, and privateindividuals lack the requisite knowledge to benchmark option and/or swap
prices. This lack of knowledge allows banks, and competing FX houses to
quote spreads that would be considered unethical by most legal bodies.
Granted, proﬁt is a natural part of business, however, fair pricing regimes
have to be established to regulate cost injustices, and that's why third party
consulting ﬁrms are necessary. Not only can we create unbiased hedgingstrategies that help companies save thousands of dollars in FX related
transaction costs, but our company ensures that your trades are carried out at
a fair price.
Hedging Products and Measuring Risk
Understanding and having the proper tools to measure risk are all important
when establishing a foreign exchange risk management program. However,
banks, and smaller brokerages are divergent in both their capability, and
focus. Banks, on the one hand, possess the speciﬁc tools to measure risk, butaren't interested in servicing the SME market. Whereas, smaller FX ﬁrmssimply lack the intellectual resources to create sustainable, and eﬀective risk
management programs. Their approach is more service driven. Brokers will
often call customers when rates move in a "favourable" direction. Theestablishment of a "favourable" rate, of course, is grounded in a self-servingneed to generate proﬁt. Don't be fooled by intellectual jargon, such as,"Fibonacci retracement series" or "Interest rate parity". These terms areutilized to camouﬂage ignorance, and are all part of a script brokers memo-rize to defend against inquiring minds. Unless traders possess a Mastersdegree or Doctorate in mathematics, their expertise can be considered
suspect, and virtually unreliable. Again, checking credentials is essential.
Hedging, or protecting your bottom-line from systemic risk has less to do withwhat Fibonacci says, and more to do with building robustness around fragile
systems where improbable events can have a huge impact on the
performance of your company.
What is Risk and How Can you ProtectYourself Against It?
Risk is a probabilistic phenomena and is deﬁned simply as the probability of
experiencing harm or loss. Risk management is concerned with risk minimi
zation. There are several existing, and working theories in risk management
that are readily adaptable, and applicable to the foreign exchange market.One such tool, called Value at Risk (VaR), is used quite extensively in ﬁnancialengineering, and portfolio management to measure the risk of loss on aportfolio of ﬁnancial assets. It's ability to capture risk as a number, provided
the underlying probability distribution and modeling techniques are sound,
makes VaR a reliable risk measuring tool. In addition to VaR, banks havecreated several products that help companies mitigate foreign exchange risk,and they include, variance swaps, futures contracts, and put options to namea few. However, simply utilizing a product is not a strategy. Receiving properguidance coupled with a clear understanding of how each hedging product
works ensures that your company is on the right path to hedging risk, andsaving money.
A forward contract, as it relates to a foreign exchange transaction, is anagreement between two parties to buy or sell a currency on a ﬁxed date inthe future, called the date of delivery. The party selling the currency, typicallya bank or a brokerage house, is said to possess a short forward position. Theparty buying, typically the client, is said to have a long forward position.Forward contracts, in simple terms, are “buy-now-pay-later” products thatallow corporate clients to lock in rates for an extended term. Banks allowcustomers to lock in rates for up to 3 years, and oﬀer zero deposit programs,given that they leverage some form of debt including a mortgage, lease, orline of credit. Brokerage houses, on the other hand, aren't as ﬂexible. Theycan lock in rates for up to one year, but in general require a 5-10% deposit asleverage, which is reimbursed on the date of delivery. By locking in rateslong-term, companies beneﬁt from eliminating all exposure to market risk.In other words, if your company buys soccer balls from the United States withCanadian currency on a daily basis, whether the currency tanks or ﬂourishesis of no concern to you because your price is ﬁxed for the entire term of the
contract. This means that companies, in addition to reducing exposure to
market volatility, also beneﬁt from locking in proﬁt margins long term.
An options contract is an agreement between two parties to buy or sell a
currency on a ﬁxed date in the future. At the onset both parties must agreeupon a price, also called the strike generally denoted by the letter "k". Thetwo major diﬀerences between options and forwards are as follows: ﬁrstly,
participants that are long (buyers) can either exercise their right to purchase
the underlying asset (currency in this case) or defect on the date of delivery.Defecting usually occurs if the market moves against the buyer. The secondkey diﬀerentiating factor is, long participants must also pay a premium inorder to engage, which serves as a form of leverage to the seller in the eventthat defection occurs. Options are a wonderful product, but can exposesellers to inﬁnite loss risks, and buyers to premium pricing risks. However,with the proper strategy in place options can serve as a beneﬁcial addition toone's currency hedging portfolio. It should be noted that options are
speculative in nature, and can expose your company to unwanted risk,
especially if you're uncertain as to the nature of the contract. Brokerage ﬁrmsand banks are known for creating confusing products they call options,speciﬁcally barrier option products, that on the surface appear safe, but can
be quite dangerous, which is why reading and understanding the contract
thoroughly is of critical importance.
Foreign Exchange Case Study
The following case study illustrates the importance of Value at Risk as a riskmeasure in foreign exchange related business activities. Before continuing,however, the concept of Value at Risk will be presented utilizing a basic
Suppose we purchase a share of stock from Company A that holds theinitial value S(0)=$200 (ﬁxed). Suppose also,
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