When banks analyze currency risk, we prefer to use advanced simulation tools to get accurate results. Our selected method is to have the analysis software generate 2000 different scenarios for future currency development and monitor the distributions worst case scenarios. We normally look at the 5% scenarios where a company has its largest loss, when assessing the risk.
There are simpler ways of doing this kind of analysis, and get a fairly accurate result. The interesting question is: How far can a currency rate move within 90% likelihood (a 90% confidence level)?
Described in a more operational context, a case like this could be: A company with EUR as it functional currency is expecting to receive a 10 million USD payment in one year. How much can the value of this USD amount change within 90% likelihood?
If we use the currency market to find the forward rate for EURUSD in one year, we can calculate the expected value of the USD payment. If the forward rate is at 1,2200, the expected value of the USD payment is EUR 8.196.721. This amount is possible to lock in using currency forward contracts.
The company is evaluating what could happen with the value of this USD payment if the currency rate is not locked in with currency forwards. What is the expected risk?
Another element of information needed to assess the risk, is the market volatility for EURUSD. This is the currency markets expected standard deviation for the year to come. The volatility is a measure on how much the market rate can move during a specified time period. This volatility is observable in the currency options market. It might be found through different sources of financial information (Thomson Reuters, Bloomberg, or your bank). If you can’t find the accurate market volatility, and you are look at currency rates between developed countries, you might use 10%. The actual EURUSD 1 year volatility is at 7,5% (November 2017).
You are now ready to calculate the simplified risk on your expected USD payment. The formula to use is this:
The number 1,65 in formula is a scaling factor.
If we input the information we have gathered, the formula might look like this:
We then end up with the risk amount of EUR 1.014.344. The market has provided us with the information that there is a 90% likelihood that the value of this USD payment will not change with more than +/- EUR 1.014.344 through one year. There is a 5% likelihood of an increase in value with more than +EUR 1.014.344. This 5% is not a concern, since the company receives much higher values than expected.
There is a 5% likelihood of a decrease in with value with more than -EUR 1.014.344. This is the company’s worst case risk.
Hence there is a 95% likelihood that the company will not lose more than EUR 1.014.344 on this USD payment in one year. You now have facts about the risk and can now asses if you want or need to hedge all or parts of the expected payment.