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Foreign Exchange Risk Management Solutions

Foreign Exchange Risk Management Solutions

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Published by ninemileco

Mitigate Against Foreign Exchange Related Risks

Mitigate Against Foreign Exchange Related Risks

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Published by: ninemileco on Jan 02, 2013
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10/23/2013

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www.ninemileco.com1.800.873.9118
PlanSolveGrow
NINEMILE
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Copyright © 2012. All Rights Reserved. The Nine Mile Management Consulting Group
Foreign Exchange
Risk Management Solutions
Elliott, G., Elliott, A. & Brar, H.
Plan. Solve. Grow.
 
Foreign Exchange Risk Management
The Foreign Exchange (FOREX) market is a market in which participants buy, sell,exchange and speculate on currencies. Participants include banks, businesses,
investment management firms, hedge funds, and retail FOREX brokers. In Canada,87% of the SME (Small-to-Medium Enterprise Business) market either imports orexports, which clearly illustrates Canada's strong dependence on foreign tradeactivity. Currency markets are highly liquid, and therefore volatile or "risky", withexchange rates changing every second. Being characterized by fragility, currency
markets are also sensitive to changes in both economic and political data including
interest rate fluctuations, balance of trade metrics, as well as GDP information. Theaverage SME in Canada suffers approximately $50,000 to $125,000 in foreignexchange losses annually, which highlights the need for companies to develop risk
management strategies that help reduce market related risk exposures.
How the Foreign Exchange Industry Works
The aim of this paper is to demonstrate how implementing an unbiased foreignexchange risk management program can help organizations save thousands of dollars in FX related transaction costs, and effectively streamline trade related
settlement processes. Conventionally importers and exporters utilize small broker
-age houses to seek out financial advice. However, this is not an effective means toreduce risk and cut costs, since the opinion of a financial institution is almost certainly
biased towards their own interests.
Why Receiving Advice from your Broker is Not a Good Idea
Brokers are sales people, not advisors. Granted some brokers do have consulting
experience, however, a good majority lack any backing in finance whatsoever, beyondthe 1 month crash course their workplace provides during probation. In fact, it's notuncommon for smaller financial institutions to hire individuals with non-quantitative
college diplomas to carry out trades, and provide haphazard advice to corporate
clients. Before doing business with your broker, ensure that you know theirprofessional, and academic background thoroughly. Just because they claim they're
a broker, doesn't mean they have the expertise to ensure that you're receiving sound
financial advice.
How do Broker’s Make Money?
Broker's in the FX industry are either paid strictly commission, or they're paid a basesalary plus commission. The commission is earned through spreads, or the absolutedistance between the client rate, and the market rate. Either way, broker's are driven
by greed thanks to monthly, and quarterly gross profit targets established by uppermanagement, which are ever increasing. In order to achieve gross profit targets,broker's have to continually drum up new business through referrals, and cold calls,
or they have to increase their spreads on existing clients. To generate new customers,
it's customary to offer teaser or under market rates to prospective clients -- once arelationship is established these near market rates, very similar to the bank of Canada
posted rates, quickly diminish. The idea is simple and it's a deceptive three step sales
one - lower price, build rapport, raise price. There's nothing wrong with this process,
 just as long as your broker is transparent about it. However, in most cases, they'renot, which is why benchmarking your rates to ensure you're getting the best possibleprice is imperative.
Where is FX Heading?
The industry as a whole is movingtowards increased transparency,
real-time access to rates, anduser-initiated facilitation of trades.
The industry is becoming open withincreased clarity.
Future Predictions
 
- Mobile trading - Consolidation of market; only a few large brokers will be left - Availability of more trading platforms - Greater transparency of market rates, real time data - Increased trading volumes 
www.ninemileco.com1.800.873.9118
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Copyright © 2012. All Rights Reserved. The Nine Mile Management Consulting Group
1
 
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.
Hedging Products
Forward Contract
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.
Options Contract
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
example.
Example:
Suppose we purchase a share of stock from Company A that holds theinitial value S(0)=$200 (fixed). Suppose also,
www.ninemileco.com1.800.873.9118
PlanSolveGrow
Copyright © 2012. All Rights Reserved. The Nine Mile Management Consulting Group
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