Advanced risk analytics and hedge portfolio optimization allow treasury professionals to better prepare for varying economic and business shifts.
In the current economic and geopolitical landscape, tail-risk scenarios seem to lurk around every corner. Corporate foreign exchange (FX) teams play a key role in managing a company’s risks and practitioners need to be mindful of the potential for crises. Best-in-class FX treasury teams need to understand advanced risk measurement concepts that provide a portfolio-wide view of their overall risk and help them manage it holistically.
- That was among the key takeaways of the H2 meeting of NeuGroup for Foreign Exchange, sponsored by RBC Capital Markets.
- James Robertson, Head of U.S. Corporate FX Sales at Royal Bank of Canada (RBC), said, “We implore FX risk managers to go from managing tail risk by targeting a discrete point in the distribution of their portfolio’s future value towards managing its variability across the broad range of probable outcomes.”
VaR versus CVaR. For corporate treasurers, value at risk (VaR) has long been a cornerstone of foreign exchange risk measurement, but as markets become more complex and the aversion to extreme risk events increases, conditional value at risk (CVaR), or expected shortfall, is emerging as a better measure for tail-risk scenarios. While VaR calculates a minimum loss over a specific time horizon at a given confidence level, CVaR calculates the expected loss beyond a certain confidence level, painting a more accurate picture of losses that occur in that region on the distribution’s tail.
- Mr. Robertson highlighted the advantage of using CVaR, “One of the problems with VaR is that it doesn’t explain how bad things can get if a tail event does occur. CVaR allows you to ask, ‘What might I stand to lose if a one-in-20 adverse risk event occurs?’”
- In an illustrative example, the RBC teams asked members to compare the size of two risks measured at a 95% confidence level for one-year EUR/USD downside risks. In the example, the expected shortfall was 40% higher than the more commonly used VaR. In this hypothetical, a practitioner would have a more full picture of the possible downside allowing them to mitigate the risk more effectively.
Factoring volatility into risk measures. How practitioners factor volatility into their models has a significant impact on their measure of risk. Although volatility derived from historic returns is easier to obtain and use, market implied term volatility paints a better picture of future risk as it incorporates the market’s expectations for price movements at various price levels thus factoring sentiment of event risk.
- Jonathan Yao, Director of Risk Structuring Solutions at RBC, pointed out that looking back at historical price data, one can examine how currency pairs have interacted, but it’s also important to consider what has been priced into the market. For instance, using a volatility measure derived from market expectations should capture something like election risk.
A close look at currency correlations. Understanding the correlations between various currencies and how they interrelate is key to helping corporates diversify their portfolios and manage risk.
- In the below comparison of USD/CAD and USD/KRW, Mr. Yao asserts that most would assume this pair is very highly correlated at first glance. But at a daily return interval, the pair is only correlated at 24%—a very low correlation.
- Mr. Yao said, “But we don’t really adjust our hedging every day. It’s more likely to be on a weekly or monthly basis.” At a weekly interval, the correlation is 44%; finally, at a monthly interval, the correlation reflects what most would intuitively expect—a very high 80% correlation.
- Mr. Robertson points out that “there are myriad periods one might choose for calculating correlation, and it’s important to understand this as a driver of portfolio analysis.”
A portfolio view. Corporate FX teams have to take the above risk measurement concepts, among others, into account when managing their portfolio of exposures. Once these risk measures are nailed down, then FX teams can get more advanced and effectively use a more diverse set of derivatives in their portfolio.
- The table below illustrates how teams can level up their FX programs with advanced risk concepts.
The RBC team further highlighted the value of utilizing a technology solution that goes beyond Excel to analyze risk and optimize hedge solutions. Leveraging a tool like one that RBC has developed for performing these types of analyses, FX teams are better equipped to make their hedging activities more efficient by varying the ratios of individual currency exposures hedged and utilizing a broader array of FX derivatives to achieve their risk management objectives at lowest cost.
- For example, it provides practitioners with an ability to analyze the economic benefit and risk-reducing properties of incorporating options into their programs at a portfolio level, and then prescribes where to deploy them.
