FOREINGN EXCHANGE EXPOSURE AND VAR

What is foreign exchange exposure:

◦ Foreign exchange exposure refers to the risk that company takes on when making transactions
in foreign currencies.

◦ If a business is looking to transact across multiple currencies, it’s important that they first
identify their exposure to risk in order to put a calculated risk management strategy in place.
Types of Foreign Exchange Exposures:

1. Transaction Exposure

2. Translation Exposure

3. Economic (or Operating) Exposure

Value at risk:
◦ Value-at-risk is a statistical measure of the riskiness of financial entities or portfolios of assets.

◦ Value at Risk (VaR) is a financial metric that estimates the risk of an investment, a portfolio, or
an entity, such as a fund or corporation.

◦ VaR is a statistic that quantifies the extent of possible financial losses that could occur over a
specified period of time.

◦ This metric is easy to understand, applicable to all types of assets, and is a universally accepted
measurement of risk when buying, selling, or recommending assets.

◦ Managers use VaR to measure and control their overall level of risk exposure.
Who Uses Value at Risk:
Value at Risk is commonly used to determine the extent and probabilities of losses in their
institutional portfolios by institutions including, but not limited to:

1. Investment and commercial banks

2. Hedge funds
3. Mutual funds
4. Brokers
When Is Value at Risk Used:
◦ Value at Risk is often used by businesses that deal with several risky investments as a way to
monitor and control the total risk level of the firm.

◦ VaR is typically used to assess company-wide risk exposure, rather than investment-specific
risk. Firms employ it to predict the size of future outlying losses or gains that their (or their
clients') portfolios may experience.

◦ Many firms use VaR to determine the amount of collateral needed from a client for a margin
loan when trading financial instruments. 

◦ Buy-side entities, such as hedge funds, use VaR to determine if a portfolio's allocation exceeds
a current risk tolerance or investment mandate.
How Value at Risk Is Calculated:

◦ 1. Historical Method

◦ 2. Variance-Covariance Method

◦ 3. Monte Carlo Simulation