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NINE MILE
Management Consulting
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Where is FX Heading?
The industry as a whole is moving towards increased transparency, real-time access to rates, and user-initiated facilitation of trades. The industry is becoming open with increased 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
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Bigger brokerage houses employ dierentiating sales strategies, since their product oerings are broader, and more diversied. In fact, larger houses are often transparent about spot rates, since any number of websites post them live. However, when it comes to talking about derivatives pricing structures, brokers tend to be dismissive, since most companies, and private individuals 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, prot 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 rms are necessary. Not only can we create unbiased hedging strategies 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
Forward Contract
A forward contract, as it relates to a foreign exchange transaction, is an agreement between two parties to buy or sell a currency on a xed date in the future, called the date of delivery. The party selling the currency, typically a bank or a brokerage house, is said to possess a short forward position. The party buying, typically the client, is said to have a long forward position. Forward contracts, in simple terms, are buy-now-pay-later products that allow corporate clients to lock in rates for an extended term. Banks allow customers to lock in rates for up to 3 years, and oer zero deposit programs, given that they leverage some form of debt including a mortgage, lease, or line of credit. Brokerage houses, on the other hand, aren't as exible. They can lock in rates for up to one year, but in general require a 5-10% deposit as leverage, which is reimbursed on the date of delivery. By locking in rates long-term, companies benet from eliminating all exposure to market risk. In other words, if your company buys soccer balls from the United States with Canadian currency on a daily basis, whether the currency tanks or ourishes is of no concern to you because your price is xed for the entire term of the contract. This means that companies, in addition to reducing exposure to market volatility, also benet from locking in prot margins long term.
Options Contract
An options contract is an agreement between two parties to buy or sell a currency on a xed date in the future. At the onset both parties must agree upon a price, also called the strike generally denoted by the letter "k". The two major dierences between options and forwards are as follows: rstly, 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 second key dierentiating factor is, long participants must also pay a premium in order to engage, which serves as a form of leverage to the seller in the event that defection occurs. Options are a wonderful product, but can expose sellers to innite loss risks, and buyers to premium pricing risks. However, with the proper strategy in place options can serve as a benecial addition to one'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 rms and banks are known for creating confusing products they call options, specically 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.
What is Risk and How Can you Protect Yourself Against It?
Risk is a probabilistic phenomena and is dened simply as the probability of experiencing harm or loss. Risk management is concerned with risk minimization. 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 nancial engineering, and portfolio management to measure the risk of loss on a portfolio of nancial 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 have created several products that help companies mitigate foreign exchange risk, and they include, variance swaps, futures contracts, and put options to name a few. However, simply utilizing a product is not a strategy. Receiving proper guidance coupled with a clear understanding of how each hedging product works ensures that your company is on the right path to hedging risk, and saving money.
Example:
Suppose we purchase a share of stock from Company A that holds the initial value S(0)=$200 (xed). Suppose also,
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that we wish to sell our share after one year. The selling price S(1) is a random variable. What we have is a stochastic process, where S represents the random stock price, which is assumed to be lognormally distributed. The way in which the random variable is distributed is important, but isn't of any immediate concern. What concerns us is our averseness or capacity to take risk. Surely we will incur a loss if S(1) < 200er where r represents the risk free rate under continuous compounding and e represents Eulers number (~2.718). Which begs the question, what is the probability of incurring a loss less than some arbitrary amount? For example: P(S(0) - S(1) < $30) = ? is the same as P(Loss < $30) = ? Now, suppose we x the probability at 0.90, for arguments sake, and x our upper bound amount, which we call VaR. This yields: P(S(0) - S(1) < VaR) = 0.90 or 90% In simple terms VaR (as above) is the probability of losing a particular amount for a set level of probability, and is used extensively as a measure in banking to manage all types of risk.
Case:
"A company manufactures goods in the UK for sale in the US. The investment to start production is 5 million pounds (GBP). Additional funds can be raised by borrowing British pounds at 16% to nance a hedging strategy - the rate of return demanded by investors bearing in mind the risk involved is 25%. The sales are predicted to generate 8 million dollars at the end of the year. The costs are 3 million pounds per year. The interest rates are 8% for US dollars and 11% for GBP. The current rate of exchange is 1.6 dollars to 1 GBP. The volatility of the logarithmic return on the rate of exchange is estimated at =15%. The company pays 20% tax on earnings."
Table 1.1 Sales Costs Earnings Before Tax Tax Earnings After Tax Dividend Result
$5 Million -$3 Million $2 Million -$0.4 Million $1.6 Million -$1.25 Million $0.35 Million or $350,000
"The result is 0.35 million GBP. Next, suppose the pound strengthens and the cross currency price becomes 2 USD for every 1 GBP, therefore investors will end up losing 0.45 million GBP as indicated by Table 1.2.
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Table 1.2 Sales Costs Earnings Before Tax Tax Earnings After Tax Dividend Result
To help your business reach its full potential, please contact us:
$4 Million -$3 Million $1 Million -$0.2 Million 0.8 Million -$1.25 Million -$0.45 Million or $350,000
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Our Consultants bring a range of diverse backgrounds, educations, and industry experiences. We constantly look for ways to solve business problems, seek growth opportunities, and leverage internal capabilities. We are passionate about what we do.
Calculating VaR allows us to determine a maximum rate for varying levels of probability. Selecting a condence level of 95% tells us that 1 GBP will never exceed 1.9650 USD (we've omitted all formulas to maintain a level of simplicity). The resultant VaR, given a 95% condence level, is approximately 392,968 (maximum loss with probability 0.95). Table 1.3 below claries.
Table 1.3 Sales Costs Earnings Before Tax Tax Earnings After Tax Dividend Result
$4.071 Million -$3.0 Million $1.071 Million -$0.214 Million $0.857 Million -$1.250 Million -$392,968
The breakeven rate according to the above VaR calculation is approximately 1.7534 USD to 1 GBP. Supposing the pound weakens then places us in a benecial scenario, with a nal balance of approximately 620,000 GBP. This example illustrates how stochastic processes can impact prots. It also illustrates the types of risks businesses face. However, the question really is, now that we know how VaR works, how can we eectively manage our portfolios exposure to risk? Of course, as discussed above, several products including options, and forwards are designed to mitigate such risk. Clearly, remaining un-hedged leaves us in a rather interesting position, since VaR tells us that over a certain time horizon our risk of losing at most 392,000 GBP is 95%. Let's show how hedging can protect us from moving markets.
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1.800.873.9118
Copyright 2012. All Rights Reserved. The Nine Mile Management Consulting Group