How can you mitigate foreign exchange risk?

One way to mitigate risk is to consider a hedging program to protect your business from the volatility of currency exchange rates. Developing a risk management plan is a good place to start, following these five steps:

1. Identify exposure
2. Specify your goals
3. Develop a plan
4. Choose your tools
5. Evaluate your results

How do I calculate Value at Risk (VaR)?

VaR is a common risk management technique to gauge downside exposures.  This involves estimating worst case or “tail risk” events.  VaR is a statistical method to provide an estimate.  First, we need to calculate the historical % returns for the asset over the given time horizon (in this case we used weekly % USDCAD returns from a ten year data set), next we calculate the mean of those returns, and finally the standard deviation of those returns.  These are the key inputs as we need to know, 1) what the average return is and, 2) how “spread out” or volatile the returns are. 

Now we can calculate our VaR estimate.  Remember, we are concerned with the worst case or tail risk outcomes, so that means we want to know what the worst 5% or perhaps the worst 1% of returns for a given week or number of weeks may look like - that way we can answer the question “how much could I expect to lose in a worst case scenario”?  

Next we have to do a little math based on the normal distribution, or bell curve.  First we take the mean weekly return and multiply it by our confidence interval of 1.65 (95% of all returns fall within 1.65 standard deviations of the mean, so this will give us our 5% worst estimated outcome).  Next we take this result and multiply it by the square root of our time horizon expressed in weeks - so if I wanted to know how much I can expect to lose over four weeks I would take the result from step 1 and multiply by the square root of 4.  Next we take this result and multiply by the notional amount of our exposure (the dollar amount) and that gives us our final result.

1. Calculate mean historical returns form a large data set. 
2. Calculate the standard deviation of those returns.
3. Calculate the square root of time for your preferred forward looking time horizon (expressed in units of your data set, for example if you have weekly returns, calculate the time horizon as the square root of the number of weeks forward).
4. Choose your confidence interval and the corresponding z-score (1.65 for a 95% confidence interval, and 2.33 for a 99% confidence interval).
5. Multiple the mean return by the z-score and then multiply that by thesquare root of your time horizon.
6. Finally, multiply this result by the notional amount of your exposure - the result is the dollar value at risk in a worst case scenario for that specific time horizon.
7. You can now answer the question: “What can I expect to lose, with a given level of confidence, over a given period of time?”

ATB can help

Contact your ATB relationship manager or ATB Capital Markets representative to find out how our financial markets experts can help your business.