Hedging FX risk is not easy. There are thousands of variables and data points that must be evaluated when trying to project where future prices might be. Institutions that trade or hedge FX often have a large division of the firm dedicated to getting a comprehensive view of all the “moving pieces” that affect the price of a currency. They attempt to get as much fundamental and technical information as possible to arrive at the best estimation of future risk. Value at Risk (VaR) is one of the tools used to assess the likelihood and size of future price movements under normal conditions.
Value at Risk: how it’s calculated and what it measures
VaR is a statistical measure used in finance to quantify the level of financial risk within a firm, portfolio, or position over a specific time frame. It has been used for decades by investment and commercial banks to determine the extent and probabilities of potential losses in their institutional portfolios. VaR is applicable to any asset class, including the foreign exchange market. It measures normal movement in a market over a specific period of time. VaR then uses statistical analysis to estimate the size and probability of movement in the future. For example, it will project with 95% certainty that over the next six months the euro will trade within a range that is 8.2% above or below its current price.
The VaR calculation in forex hedging involves several steps:
- Data Collection: Historical data on exchange rate movements is gathered in order to make accurate calculations. The more data points and the longer the time series, the more accurate the VaR calculation can be.
- Volatility Measurement: Historical volatility of exchange rates are also calculated. This involves determining the standard deviation of exchange rate returns, which quantifies the dispersion of historical price data.
- Portfolio Valuation: Current market value of the FX portfolio is determined, which includes the various currency positions.
- Covariance Calculation: Different currencies in the portfolio are assessed as they move in relation to one another. This can help determine if certain positions offset each other's risk or not.
- Value at Risk Calculation: Once the necessary data and calculated volatility and covariance is collected, you can determine the VaR at your chosen confidence level and time horizon. This involves using statistical models, such as the historical simulation method, the parametric method, or the Monte Carlo method.
Sounds complicated, doesn’t it? But VaR is an integral part of due diligence on the part of firms and portfolios that want to protect their assets. And it’s why FX management can often be daunting for small to medium sized companies.
That’s why Pangea Prime™ is powered by Ai. Pangea’s platform quickly analyzes FX data and produces a VaR calculation for any currency in seconds. In just a few clicks, Pangea Prime™ shows the expected risk associated with any FX pair and creates a graphic called the “risk cone,” showing expected risk with 95% certainty.
The graphic below shows potential (unhedged) risk and how that risk can be reduced through appropriate hedging.
This means you don’t need to have a team of quants to do the math. Pangea Prime™ does all the heavy lifting for you so that you don’t have to spend valuable resources on tedious, manual calculations.
VaR is one of many tools used to quantify FX risk by Pangea Prime™. It gives a good estimate of risk under normal conditions. It cannot predict the effects of unexpected events, also referred to as “tail risk”. Even still, Pangea’s intelligent Ai monitors currency markets 24 hours a day and uses decades of data to analyze how currency may impact your P&L. A comprehensive hedging strategy should consider all possible variables that could put a company at risk.
With Pangea, you can hedge FX risk, strategically manage your global FX accounts, deliver FX payments virtually anywhere in the world, and manage your FX all from a single platform. Pangea’s Ai puts the same powerful strategies and tools used by Coca-Cola, such as financial derivatives and hedging instruments, in the hands of your treasury and finance team—without the large overhead of a Fortune 500 treasury staff.
Here’s how you can get started:
- Talk to one of Pangea’s Advisors about your international business activity and FX exposure.
- Create an account and onboard onto Pangea Prime™.
- Begin hedging your company's foreign exchange risk through the Platform.
Schedule a demo today and get the predictability and control you deserve in your business.
Pangea Prime: Predictable, simplified FX management.