Remember the story of the three little pigs? If you’ve ever leaned against a brick wall, you know the unsung hero of the story was mortar – the cement that connects every brick so the wall stays intact, and serves its purpose. Though bricks were glorified for holding the big, bad wolf at bay, without mortar, the wolf would have hosted a very fine luau. Our title, Put Confidence in Your FX Strategy, is not to suggest companies should place blind faith in their FX risk management strategy. It asserts that the way to build a strategy is to include confidence among the materials used, like the mortar in a brick house.
Our prior post introduced value-at-risk (VAR), a probability-based measure of downside risk of the financial metrics you want to protect. In that post, we illustrated how VAR lets you decide how much confidence is enough. This article focuses on VAR’s close relative, the confidence interval (“CI”). Analytics such as VAR and CIs (aka, mortar) should be used to design and build brick house strategies out of conventional risk management activities (bricks) to avoid being eaten by a wolf.
Confidence Intervals and Market Variables
A confidence interval can be used to assess the volatility of future market outcomes, which is useful for analyzing exposures and hedging strategies.
A confidence interval can be used to assess the volatility of future market outcomes, which is useful for analyzing exposures and hedging strategies. Just as users can choose how confident they need to be in VAR’s output (e.g. 99%), they may select CIs suitable to validate their hedging strategies (“CI 99%”).
The following graph is commonly called a volatility cone, which illustrates the “expected” outcome of a market variable together with outcomes at one or more CIs, over time. This one shows the downside distribution of a long EUR versus USD over a one-year horizon at various CIs.
Evaluating Strategies using CIs
How can CIs help you analyze exposures and hedging strategies? Say your company’s EURUSD target rate for 2020 is 1.1600, which stems from your FX objectives. Also suppose your company’s FX policy required you to hedge half of its 2020 FX exposures by the end of 2018, so 50% of forecast revenues for April, 2020 were hedged at a rate of 1.1900. Given that 50% of the exposure is “locked in” at 1.1900, you must convert the balance at 1.1300 or better to achieve the target rate of 1.1600. But when and how should you convert the balance? Here’s how you can use risk analysis based on CIs to decide.
What do our CIs indicate about the likelihood your unhedged EUR revenue can be converted at 1.1300 in a year? At a glance, our CIs explain there is a 10% probability (CI90%) the EURUSD will trade below 1.0752, so the probability of sub-1.1300 EURUSD is higher. Indeed, there is a considerable chance EUR will be below 1.1300 (about 32%). So, if you don’t hedge more, your strategy is 32% likely to fail to meet its objective.
Hedging the entire balance at the one-year forward rate (1.1627) would establish a weighted average rate of 1.17635, however, your company prohibits hedging more than 90% of forecast exposures to avoid becoming over-hedged due to forecast error.
By executing a one-year forward hedge against an additional 35% of the exposure today, you ensure that your company’s 2020 EUR revenues will be converted at a weighted average rate of 1.1597 with 95% confidence. That is, there is only a 5% probability your strategy will fail to deliver the target conversion rate of 1.1600 (by more than 3 pips). This strategy locks 85% of the conversion rate via forward contracts executed on 12/31/18 and 4/13/19 at a rate above the target. So, even if EURUSD falls to 1.0516 (CI95%), the weighted average conversion is just a sliver beneath your target rate.
Strategy 3: Higher Confidence
What’s more, by executing Strategy 3, there is only a one-in-one-thousand chance the weighted average conversion rate will be 1.1464 or lower.
Bricks + Mortar = Reliable Strategy
The value of CIs to create reliability in your strategy is clear
While the above example is intentionally narrow in scope, the value of CIs to create reliability in your strategy is clear. The same sort of risk analysis can be applied to your company’s comprehensive FX risk strategy.
Conventional activities, such as gathering exposure data and executing hedges, are the bricks from which you build good strategy. But risk measurement and analysis must be your mortar to introduce cohesion and continuity to your results.
 Most commonly, a volatility cone presents both “upside” and “downside” volatility. Our illustration considers only long EUR position, therefore EUR downside is the only “risk.”
 The target rate might be the 2020 budget rate or it might be set as part of a strategy to manage the year-on-year impact of FX in relation to conversion rates achieved for 2019. We will address these rates in more detail in future articles.
About the Author
Chuck Brobst is the Managing Director of Analytics and Innovation Strategist at OANDA Corporation. He teaches graduate courses on risk management and banking at DePaul University. Previously, he founded GFM Solutions and spent 15 years in global markets divisions of BAML and ABN-AMRO Bank.
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