Especially in today's internationally connected business world, it is often unavoidable even for smaller companies to engage in a wide variety of transactions in foreign currencies. Many orders are, for example, only possible or significantly cheaper in other currencies.
However, for each position entered into in a foreign currency - for assets as well as for liabilities - there are considerable risks from fluctuations in exchange rates.
Several procedures from Financial Risk Management have proven their worth in quantifying these so-called foreign exchange rate risks (FX risks) and have been established with financial service providers and larger companies for years.
Two key indicators are sensitivity and Value at Risk (VaR).
The sensitivity indicates how much the value of a foreign currency position changes if the exchange rate of the corresponding foreign currency increases by (here) 1%.
The VaR, on the other hand, indicates the extent of the loss that will not be exceeded at a certain confidence level (e.g. 95%) and a certain time horizon ("holding period"; e.g. 10 days). A key challenge in determining VaR is also to take account of correlations between exchange rates; in the case of uncorrelated exchange rates, this tends to lead to diversification and thus to a reduction in the overall risk compared with pure addition. Two following common methods are used here for determining VaR:
Delta Normal Approach: Variances and correlations are determined on the basis of the history and calculated using the normal distribution assumption of VaR. This approach is easy to implement, but underestimates unlikely events.
Historical simulations: The historically observed changes are used as simulation scenarios. This method implicitly takes correlations and possible shocks into account, but its quality depends strongly on the underlying history.
For our app we use the histories of the last 1000 days for both methods.
The RiskDataScience forex risk calculator enables the determination of exchange rate risks for portfolios of up to 19 foreign currencies from the perspective of 5 local currencies.
Thus, even smaller companies with no sophisticated financial risk procedures can obtain an indication about possible FX risks of planned or actual deals or transactions.
A batch run determines the exchange rates of the latest day for which data were obtained (value date); please note that all the calculations refer to this day. After selecting the local currency and entering the foreign currency positions (each in foreign currency units), the holding period (in business days; please note that the value for meaningful results should lie between 1 and 250), and the confidence level (in %) for the value at risk, the calculation can be started.
The results are
- the total cash value in local currency
- the delta normal VaR and the historical VaR
- the present values of the foreign currency position in local currency
- the sensitivities of the foreign currency position (1% increase in foreign currency) in local currency
- and the total NPV scenarios from the historical simulation
are graphically displayed (see below).
We support our customers with these as well as further financial risk methods – e.g. for calculating interest rate or credit risks – and with questions regarding more current data sources.
Dr. Dimitrios Geromichalos
Founder / CEO
Nördliche Münchner Straße 47, 82031 Grünwald