Measuring FX Risk: Crises with Confidence

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Corporate treasurers do more than ever before to identify and mitigate risk and to position their companies to weather market crises with confidence. According to Deloitte, 85% of companies are measuring their sensitivity to market risk, but a much smaller portion regularly assess the probability of their risk. [1] Our last post explained that managing risk is about understanding uncertainty. But probabilistic risk measurement is about more than likelihood, it is about confidence

If you are an experienced treasurer or risk manager, you are probably familiar with “value at risk,” commonly called “VAR.” [2] Even if you have used it, you might not recognize VAR’s full benefit. This article will define VAR and explain it in the context of FX risk management.


What is VAR?

Just as the name implies, value-at-risk measures the downside risk of exposures. Casual users sometimes refer to VAR as a “worst-case” outcome – which is not exactly correct – but easily corrected. VAR is the worst case given the degree of confidence expressed. Every VAR measurement provides output that could be stated like this: 

  • I am [X]% confident that the potential loss on my [exposure] will not be worse than [VAR] in [time period].

  • Example: I am 95% confident that the loss on my $10,000 portfolio will not be worse than $400 in 3 months. 

Let’s view that statement from both angles, to be clear. 

  • There is a 5% probability the loss on my $10,000 portfolio will be worse than $400 in 3 months.

  • “Worse than $400” means the loss might be $401, but it is also possible the loss will be $1,000. VAR does not tell us “how much worse” the loss might be. 

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To measure your FX risk, you might perform VAR analysis on the USD value of forecast FX revenues. 

  • Let’s say, in April, 2019, you forecast EUR 1 million of revenue to occur in July, 2020 (15 months). The forward rate is EURUSD 1.1700 (expected value). So, you expect the value of EUR revenues in July, 2020 to be USD 1.17 million. 

  • Using VAR to understand your FX risk, you conclude you are 95% confident that your forecast EUR 1 million of revenue will not lose more than USD 131,821 of the expected USD 1.17 million by the time it is recognized, in July, 2020.

  • When communicating to executives, you might express the recognized USD revenue you are 95% confident your company will recognize, rather than the amount that might be lost, as follows:

  • You are 95% confident that your forecast EUR 1 million result in recognition of at least USD 1.0382 million of revenue in July, 2020. 


Increase your Confidence 

VAR is unique from other risk measures because you can tailor it based on your need for confidence in the output. When your CEO says, “95% is not confident enough!” you simply increase your confidence interval. To increase confidence in your “worst-case” revenue estimate, naturally, your VAR will reflect the potential for a greater decline in the value. 

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Just remember, VAR does not guarantee worst-case results. It is a probabilistic statement of confidence. Even 99.9% confidence means 1 out of 1,000 times, the USD value of EUR revenue would fall below $0.934 million – and how far below – VAR will not say. 

Our next article will explain how confidence intervals can be applied to market variables like FX rates to help you understand how reliably alternative FX risk management strategies will perform to meet your objectives.

 

[1] 2017 Global Corporate Treasury Survey: Continuing the evolution from operation to strategic.

[2] Alternatively, you might know of CFaR (“cash flow at risk”) or EAR (“earnings at risk”). Both are variants of VAR using the same tools in a specific context and framework.

[3] General market level as reported by Investing.com on April 13, 2019.

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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