Relevant to the following CISI qualifications: Risk in Financial Services, Derivatives
The successful management of a portfolio includes maximizing returns from shifts in exchange and interest rates, which in turn requires an appreciation of the associated exposures. Not knowing the exposure can leave the portfolio open to significant risk.
Exchange rate risk is the risk arising from a change in the price of one currency against another. Companies or institutions that trade internationally are exposed to exchange rate risk if they do not hedge their positions. There are two main risks associated with exposure to exchange rates.
- Transaction risk arises because exchange rates may change unfavorably over time. The best protection is to use forward currency contracts to hedge against such changes.
- Translation risk concerns the accounts, and the level of risk is proportional to the amount of assets held in foreign currencies. Over a period of time, changes in exchange rates will cause the accounts to become inaccurate. To avoid this, assets need to be offset by borrowings in the affected currency.
The significance of the exposure will depend on the portfolio’s weightings and operations. Identifying the level of risk in the above exposures should help with selecting a suitable defense strategy.
Interest rate risk relates to changes in the floating rate. Failure to understand exposure to interest rates can lead to substantial risk. The two main areas of concern here should be borrowings and cash investments. The best way of appreciating exposure to changing interest rates is to stress-test various scenarios. How, for example, would a change in rate from 4% to 6% affect your ability to borrow?
MITIGATING THE RISK
EXCHANGE RATE EXPOSURE
Other than the two strategies mentioned above, good strategies for minimizing exchange rate exposure involve employing one or more of the following products.
- Spot foreign exchange: An obligation to buy/sell a specified quantity of currency at the current market rate to be settled in two business days.
- Structured forwards: Exchange forwards embedded with, generally, more than one currency option. This adaptation allows a more effective hedge and should improve the exchange rate within the client’s perception of the market.
- Currency options: An option to the right to buy/sell a certain amount of currency at a specific exchange rate on or before a specific future date.
INTEREST RATE EXPOSURE
Once identified, the risks can be minimized using the following methods:
- Interest rate swap: A method for changing the interest rate you earn/pay on an agreed amount for a specified time period.
- Cross-currency swap: An exchange of principal and interest payments in separate currencies.
- Forward rate agreement: Two parties fix the interest rate that will apply to a loan or deposit.
- Interest rate caps: The seller and borrower agree to limit the borrower’s floating interest rate to a specified level for a period of time.
- Structured swap: An interest rate/cross-currency swap embedded with one or more derivatives. This allows the client to minimize his exposure on his perception of the market.
The one key advantage to identifying exposure to interest and exchange rate fluctuations is the ability to minimize possible losses in the event that your view of the market is wrong. This approach will also minimize the chance of unexpected events disrupting the investment strategy.
As with any hedge strategy, minimizing possible losses also reduces potential gains. Only those who are supremely confident in their forecasts and with a cushion to absorb losses should consider taking any extra risk to maximize returns.
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