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Straight-through
processing for Forex
Pre-trade market risk analysis
in e-forex platforms
In a world where currency traders, portfolio managers and
corporate treasurers are pursuing ever more sophisticated
investment strategies, it is becoming increasingly difficult to
properly assess the true risk profile of certain positions. This is
especially true in the forex trading market where complex
products such as path-dependent barrier options are used to
establish direction trades or when the underlying currency
exposure arises from a position in multifaceted products such
as structured notes or convertible bonds.

Investors historically have analyzed their currency exposure in

isolation and under simplistic assumptions with respect to the
timing and magnitude of the expected cash flows they are
trying to hedge. As a result, hedging currency exposure usually
entailed assessing “par value” or “nominal” currency exposure
and subsequently hedging the portion deemed unacceptable
using plain-vanilla currency options or foreign-exchange
futures. This practice is however often sub-optimal because it
fails to account for the natural diversification occurring between
different sources of risks embedded in a portfolio. Also, it fails
to account for the fact that portfolio managers and treasurers
usually want to mitigate their downside risk (potential losses)
and not necessary eliminate their currency exposure. A new
approach allowing better identification of the risks supported is
undoubtedly needed.
For instance, before hedging a portfolio for its currency risk,
portfolio managers may want to identify and segregate their
exposure to specific movements in interest rates, credit spreads
and foreign exchange rates. Different conditional-expectations
scenarios can then be applied to assess the true amount of
downside risk actually faced by the investors. Ultimately, only
the exposure deemed unacceptable should be hedged using
custom-made and cost-effective derivative products such as
credit and currency derivatives. The emergence of specialized
products such as credit default swaps, total return swaps and
credit spread options enables portfolio managers to eliminate or
mitigate credit risk exposures, while currency derivatives such
as vanilla or complex FX options allows them to alter their
currency exposure.
“..monitoring currency
exposure requires a
sophisticated risk engine…”
In other words, the presence of tailored products allows
investors to neutralize very specific exposure. This, coupled
with the ability to segregate sources of risk with greater
granularity, will undoubtedly lead to the use of more
meaningful, effective, and tailored hedging strategies, especially
in liquid markets such as the currency market. However,
complex and tailored hedging strategies must be supported by
appropriate analytical tools to assess risk and return in order to
fulfill their true potential.
In today’s world, monitoring currency exposure requires a
sophisticated risk engine capable of supporting complex
derivative products, of analyzing aggregated portfolio exposures
across several dimensions, and of conducting horizon analysis
in a consistent manner. However, sophisticated risk systems
have historically been costly and difficult to maintain.
More importantly, they were difficult to use, lacked flexibility
and were for the most part, fairly unintuitive. This created a
situation where only very few managers could own such a risk
system; and even fewer could use the technology to its fullest
potential. There is no doubt that the inability of portfolio
managers to properly assess the true risk profile of their
positions and the true impact of certain derivative products has
hindered growth in the currency derivative trading area.
Portfolio managers will only invest in complex products once
they fully understand the risk profile and profit enhancement
capabilities of those products.
This is why certain risk providers have invested millions of
dollars developing a new suite of risk management products
that are better suited for complex trading and enhanced
usability.
These products were specifically designed to support non-linear
products such as options and convertible bonds. But the main
area where these products really distinguish themselves is that
they can be fully embedded within a trading platform. This
approach completely removes implementation risk, reduces
maintenance cost, enhances security and facilitates data
reconciliation. Most importantly, it allows investors to conduct
truly real-time risk analysis and what-if scenarios on their
positions.
“But reducing failure rates
is not the only focus for
risk managers…”

68 april 2003 e-FOREX april 2003 e-FOREX 69

 FX Straight-through processing for Forex

confidential Another key benefit of embedding sophisticated risk management

tools within a trading platform is that it significantly mitigates
operational risk. This is achieved by reducing the amount of data
transferred from one system to another and aligns the middle office
with the front office. Since both the analysis and execution are
handled by one system, there is effectively a greater control over data
flow and lower likelihood of costly operational failures. But reducing
failure rates is not the only focus for risk managers in a business
environment.

Indeed, for banks, a key measure of competitive advantage and

business effectiveness is use of capital in risk trading areas. And
increasingly, it is not just market and credit risk that must be factored
into costs and pricing, but also operational risk. Errors in processing
deals at regulated financial institutions will in the future have a capital
implication. This must be modeled within the overall risk management
environment, in particular if the organization is to calculate the true
At FXall, we don't trade in the return on economic capital invested in the forex business.
FX market. We don't take
positions. There's no conflict With currencies swinging up and down at a dizzying pace and financial
with your interests. Our mission markets reacting more vividly to economic news, investors are facing
is clear – to ensure clients and unprecedented portfolio volatility. If history is any guide, this volatility
providers alike trade in an is here to stay and will fundamentally change the nature of investment
efficient environment where strategies undertaken by professional investors and corporate
the rules are fair. treasurers. With new and more complex strategies comes the need for
equally powerful risk measurement and management systems that

Your confidential trade truly capture the total risk undertaken by an investor. Whether an

information is secure. Your investor is facing market, credit or operational risks, these risk must be
well understood, quantified and managed. And the trading platform is
account details and client
the logical place to do so in an integrated and efficient way.
records will not be compromised.

When you're selecting a portal,

ask the big question: Who else
has access to your data and how
can they use it?

all dealt, confirmed and

settled – confidentially
Issued by FX Alliance Limited, regulated by FSA.

Benoit Fleury.
Director, Algorithmics Bloomberg Solutions
with contributions from David Syer
and Andrew Aziz

www.fxall.com