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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. 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. 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. 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. 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. 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.

“..monitoring currency exposure requires a sophisticated risk engine…”

“But reducing failure rates is not the only focus for risk managers…”
april 2003

68

april 2003

e-FOREX

e-FOREX

69

Straight-through processing for Forex
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 return on economic capital invested in the forex business. With currencies swinging up and down at a dizzying pace and financial markets reacting more vividly to economic news, investors are facing unprecedented portfolio volatility. If history is any guide, this volatility is here to stay and will fundamentally change the nature of investment strategies undertaken by professional investors and corporate treasurers. With new and more complex strategies comes the need for equally powerful risk measurement and management systems that truly capture the total risk undertaken by an investor. Whether an investor is facing market, credit or operational risks, these risk must be well understood, quantified and managed. And the trading platform is the logical place to do so in an integrated and efficient way.

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