Value at Risk Using Variance Covariance Method

Value at Risk Using Variance Covariance Method:

The total investment would be:

Investment = $2000 * 10000

Investment = $20,000,000

Following the normal distribution, the z score for 95% confidence interval has a value of 1.645 for one sided confidence level.

Value at risk = $$20,000,000 * 1.645 * 8%

Value at risk = $2,632,000

Value at risk = 13.16 %

Therefore, with 95% confidence interval, the maximum lost would not exceed $2,632,000 i.e. 13.16%.

The parametric strategy, otherwise called the change covariance technique, is a hazard the executive’s method for figuring the incentive in danger (VaR) of an arrangement of benefits. The incentive in danger is a factual hazard the executive’s method estimating the most extreme misfortune that a venture portfolio is probably going to look inside a predefined time span with a specific level of certainty. The change covariance technique used to compute the incentive in danger distinguishes the mean, or anticipated worth, and standard deviation of a speculation portfolio. (Analytical Approach to Calculating VaR (Variance Covariance Method) Finance Train, no date)

Value at Risk Using Historical Stimulation Method:

The results from the calculations are as under:

Table 1: Normal Distribution VAR

Table 2: Historical Simulation VAR

The descriptive data is tabulated below:

Table 3: Descriptive Analysis

The frequency distribution for the historical exchange rate is plotted as under:

Figure 1: Histogram for the daily gain/ loss

Interpretation:

 It is the measure that find the risk across and get to know how much maximum does the loss could occur for the specific equity or the combined portfolio (Historical VaR — Northstar Risk, no date).

For the calculation of VaR (Value at Risk) using the historical simulation method the fundamental assumption was that basis basically the past performance of the script under study and making an assumption for the measure of performance, the past information is a worthy measure. (Calculating VaR Using Historical Simulation Finance Train, no date).

With the above calculation, the results show that with 95% confidence interval, the maximum loss that could be held with this parity of GBP/ USD is 44.4%, the worst case scenario.

Currency Forward Hedge Strategy:

In the foreign exchange market, the Currency Forward basically an agreement, which allows the locking of exchange rate only to buyer on the day this agreement is signed for sale and purchase of currency on the upcoming dates. It also known as forward contract. Forward contracts are basically the customizable hedging instrument that does not involve an upfront margin compensation. This is being one of the principle strategies which is used to hedge in contradiction for exchange rate instability, as they maintain a strategic distance from the effect of money vacillation over the period secured by the contract. The another critical preferred position of a forward agreement is that its conditions and term are not standardized and for a particular amount and for any development period can be custom fitted, dissimilar to trade exchanged money fates. It is effective hedging resource and grant buyers to demonstrate the particular signify be exchanged and the date on which to settle in the forward understanding (Forward Contracts, no date).

Using the given financial instruments and calculating the expected gain by using this hedge strategy.

Expected gain ($) = $20,000,000 (1.2496 – 1.24)

Expected gain ($) = 192,000

By using this hedge strategy, the company increases its dollar expected receipt by $192,000 and exclude risk.

If we want to calculate the euro cost it will be $20,000,000 / 1.2496 = €16,005,121.64

Relationship between the Payoff and Profit and Future Spot Exchange Rate of Currency Forward Hedge Strategy:

Long position gains = no. of units (ST – FtT or K)

Where,

ST = Future Spot Price

FtT or K = Future price or delivery price

Short position gains = no. of units (FtT or K ST)

Where,

ST = Future Spot Price

FtT or K = Future price or delivery price

The payoff for the long position will be,

Long position Pay off = ST – k

Where,

ST = Future Spot Price

FtT or K = Future price or delivery price

The holder for the long price is committed to purchase the securities which would trade for delivery price at spot price.

The payoff for the short position will be,

Pay off short position = K ST

Where,

ST = Future Spot Price

FtT or K = Future price or delivery price

The holder for short price is committed to sell the securities which would trade for delivery price at spot price. (CHAPTER 8 MANAGEMENT OF TRANSACTION EXPOSURE SUGGESTED ANSWERS AND SOLUTIONS TO END OF CHAPTER QUESTIONS AND PROBLEMS QUESTIONS 1. How would you define transaction exposure? How is it different from economic exposure?, no date)

Money Market Hedge Strategy:

Money market are the business sectors of discount loaning and obtaining or exchanging transient money related instruments. Hedge of money market is used for hedging foreign exchange risk in that market, the market which have high fluid and momentary instruments alike commercial papers, treasury bills trade. The money market hedge may not be the most viable or beneficial course for gigantic associations and foundations to fence such peril. In any case, for retail money related masters or private endeavors wanting to fence cash hazard. The money market is one way to deal with guarantee against cash instabilities without going into a forward agreement or using the future market. It is basically a technique used for currency managing and foreign exchange risk. It permits an organization to secure an exchange rate with the overseas party ahead of transaction. It likewise offers some adaptability, for example, hedging just the half of the estimation of exchange. Money market are regularly more entangled than different types of remote trade like currency forward. Without money market hedge residential organization would be liable to exchange rate fluctuation that could significantly modify the exchanges cost. While changes in exchange rate rates could make the exchange become more affordable, variances could likewise make it progressively costly and potentially cost restrictive.(ACCA FM (F9) Notes: Money Market Hedge Receipt | aCOWtancy Textbook, no date)

Since the company invested in the dollar of $20,000,000 for one month, the dollar amount the company receive is,

$20,000,000 (1.004) = $20,080,000

Will is clearly less than the one received in company forward hedge.

The euro cost in money market hedge case will be

$20,000,000 (1.003) / (1.004) (1.24)

€ 16,112,967.5

Relationship between the Payoff and Profit and Future Spot Exchange Rate of Money Market Hedge Strategy:

The amount borrowed is calculated as (International Financial Management Thummuluri Siddaiah Google Books, no date):

Where r is foreign currency borrowing rate

The domestic deposit can be calculated as:   

Where r shows the rate of domestic deposit.

Currency Option Hedge Strategy:

An option that gives the purchaser an option but not the commitment in an agreement to either purchase or sell at the current predefined rate with predetermined conversion scale, a specific portion of cash is known as Currency Option Hedge Strategy. This is executed with the charging of a premium to be applicable. Currency option also allows the brokers to secure cash opportunity or to fix the moves by hypothesizing basis predetermined rates. This hedging strategy is the most common among the business transactions and is most widely implied too. It also come in two fundamental assortments, purported vanilla choices and over the counter SPOT alternatives.

Call option provides the agreement holder the right (though not a firm commitment) to purchase a fundamental stock or currency at a predefined rate (referred to as             the strike cost), for a defined span of time. With the chance that the stock or currency is not being able to meet the strike cost before the expiry of the defined time, the choice gets useless now. Financial Managers do prefer purchase calls in a situation when they think that the offer price of the security will increase or to sell on the base of the chance that they foresee it will surely fall. Selling of a stock is indicated as making an alternative (Money Market Hedges, no date).

Put option provides the agreement holder the option to sell a stock or the currency at a predetermined rate (referred as the strike cost). The trader of the alternative is obliged to purchase at the strike cost. Put choices can be utilized in a situation whenever before the alternative gets terminated. Financial managers purchase puts on the off chance that they foresee that the offered price of the stock or the currency will ultimately fall, or sells one on the off chance that is being predicted to rise again. Put purchasers the individuals holding a long put are either theoretical purchasers who are continuously searching for the protection purchasers with which their long term position will be secured by another alternative. Whereas, put venders hold a short position predicting that the rates will move upward (or possibly remain stable). The cost of premium is recovered at the time of the expiry of the elapsed time of the agreement, this is one of the biggest advantage due to which the premium is ready to be paid. (Currency Forward Definition, no date).

Using 1st call option:

Total option premium = $0.0187 x $20,000,000 = $374,000

In one month, $374,000 is worth $374,000 x 1.004 = $375,558

The expected spot rate is 1.2496 which is higher than the exercise of 1.225.

Similarly, we can calculate other call option too.

Relationship between the Payoff and Profit and Future Spot Exchange Rate of Currency Option Hedge Strategy:

We define the put call parity according to the equation below:

C = e ^{if T} *S + X* e ^id *T

It must be noted that the premium of the put option depends upon the following six factors:

1. The strike price (X)
2. Exchange rate prevailing (S)
3. Time remaining in the expiry of the term (T)
4. The exchange rate volatility (s)
5. The interest rate of the domestic market (id)
6. The interest rate of the foreign market (if)

Costs and the Benefits of Currency Forward Hedging Strategy

Fluid and focal market: The execution of this type of contracts builds the liquidity in the market since these are traded in the focal market. The market or the exchange consists of many members who can accessibly trade such contract via buying and selling of the options. The chance of the mishap or the accidental event occurring is decreased because of such high liquidity. For instance a broker can without much resistance or stretching may take off his position and close the contract owing to available enough liquidity in the market, this component is missing in the forward market where the market participants could not affect they particular deal or the contract (How Forward Contracts Hedge Risk in Foreign Markets | Study.com, no date).

Influence: The markets edge framework may influence the entire contract, this happens when the breaker starts taking the position with a few unit or total amount and so a small change in the spot may badly influence contract manifolds. For example, with the one percent change in the fate cost may lead to the ten percent change in the underlying hedge because of the big ratio between the two. This intensifies the exposure and is termed as the influence and can be on both ways gains or the misfortunes.(Currency Forward Definition, no date).

Positions can be effortlessly finished off: with an option for the inverse exchanges, the undertaken position can easily be finished off a part. For example, a dealer sold a dealer sold $100 fate contract with the expiry date of latest by December 31. Within this time, dealer could close this fate by purchasing a $100 fate. With most of such counterbalancing finish offs realizing near the maturity date for as being off to definite of the prices now. This helps in mitigating the risks (How Forward Contracts Hedge Risk in Foreign Markets | Study.com, no date).

Intermingling: The spot price and the contract price gradually appears to be similar as the remaining time of the contract diminishes and on the date of the expiry the two are equally identical. This act or the process is termed as the union or the intermingling. This is enforced by will by the trader in order to benefit with the difference of prices between the spot and the trade price as significantly positive in other words just like purchasing in the les expensive market and selling the same in the market with elevated prices (Currency Forward Definition, no date).

Costs and the Benefits of Money Market Hedging Strategy

The money market hedge like a forward agreement, fixes the conversion scale for a future exchange. This can be positive or negative, contingent upon cash variances until the exchange date. For example, in the past case of fixing the euro rate, you would feel shrewd if the euro was exchanging at state 1.40 by excursion time (since you had secured a pace of 1.3550), yet less so in the event that it had plunged to 1.30.

The money market hedge can be modified to exact sums and dates. In spite of the fact that this level of customization is likewise accessible in money advances, the forward market isnt promptly available to everybody.

The money market hedge is more entangled than customary cash advances, since it is a bit by bit deconstruction of the last mentioned. It might accordingly be appropriate for supporting infrequent or irregular exchanges, yet as it includes various particular advances, it might be unreasonably lumbering for visit exchanges

There may likewise be calculated imperatives in actualizing a currency showcase fence. For example, masterminding a generous credit sum and setting outside monetary standards on store is lumbering and the real rates utilized in the currency advertise support may change fundamentally from the discount rates that are utilized to value money advances (How the Money Market Hedge Works, no date)

Costs and the Benefits of Currency Option Hedging Strategy

1. They are exceptionally modest to exchange
2. They are accessible on or off trade
3. Hazard is restricted to premium (on the off chance that purchaser is you)
4. Extremely chance versus high potential returns
5. Heaps of methodologies to guess on instability and value development
6. They can be illiquid
7. Immediately become useless
8. Hazard is conceivably boundless (on the off chance that you are a vender

(Currency Option Definition, no date)

Recommendation for Hedging Strategy

The hedging is being utilized by the corporations to use the foreign currency exchange options for the uncertain cash flows in a foreign currency. The general rule of thumb is that if the foreign currency cash flows are certain then they are to be hedged with forwards and if the foreign currency cash flows are uncertain then they are to be hedged with the options (Foreign exchange option Wikipedia, no date).

 Here in this case, since the British Company has sold 10,000 units to an American Company at the rate of $2,000 per unit. The net receivables for The British Company is $20,000,000/ that is the cash flows of the foreign currency ($ terms) are certain therefore, it is recommended to hedge the currency forward to mitigate the risk associated.

Forward Contract, as suggests that the price of the pound/ dollar exchange to be specified at the time of the sales of the units in order to avoid the loss due to the increase in the value of the dollar. As a result, will help the company to exactly match its exposure, perfectly hedging their forex risk. That is while going for the forward contract for the $20,000,000 (1.24003) at the time of the selling of the goods to be paid within a defined credit period at a price a bit lower to £24,992,000 / this can be beneficial if at the expiry of the credit period the value becomes £24,792,000/ due to Dollar appreciation (0.02) Savings of £200,000/ for the British Company.

Another gain as evident from the given data is the difference of 0.0096 in the exchange rate for the forward and the spot rate. With the forward contract the company will gain £192,000/ in relevance of spot and forward.        

The real profit in this certain cash flow case is to ensure the hedging the risk to not to wiping out the potential profits (How To Use A Forex Hedging Strategy To Attain Low Risk Profits, no date). With this Case to secure the potential £200,000/ which could have wiped off.

Secondly, there are no upfront cost of the hedging to be paid for the forward contract, since it is free while with the call option a cost has to be paid off in the form of a premium for the contract up fronts.

With this strategy of currency forward the company can mitigate the possible post regret that it might have to suffer from the might dollar appreciation

Further it is relatively straightforward to use the forward contract and is very comprehend to organize in the sense that the calculation is simple and determined today and mitigating the movement of the currency exchange in the future and at the time of payment the profit or the opportunity can be easily determined by the rates fixed (forward rates) and the spot rates then

This is quite evident that without taking the delivery in this case well before the expiry of the credit period the incoming exact inflows in the futures is defined

The margins of the exchanging of the currency in the forward market are also very low as compared to the spot market due to the high liquidity and the post settlement. The company will save on the currency exchange margin costs, (CHAPTER 8 MANAGEMENT OF TRANSACTION EXPOSURE SUGGESTED ANSWERS AND SOLUTIONS TO END OF CHAPTER QUESTIONS AND PROBLEMS QUESTIONS 1. How would you define transaction exposure? How is it different from economic exposure?, no date)

With above reasoning, it is recommended for the British Company to adopt the currency forward for its receivables.

References

ACCA FM (F9) Notes: Money Market Hedge Receipt | aCOWtancy Textbook (no date). Available at: https://www.acowtancy.com/textbook/acca fm/g3 hedging techniques for foreign currency risk/money market hedge receipt/notes (Accessed: 18 May 2020).

Analytical Approach to Calculating VaR (Variance Covariance Method) Finance Train (no date). Available at: https://financetrain.com/analytical approach to calculating var variance covariance method/ (Accessed: 18 May 2020).

Calculating VaR Using Historical Simulation Finance Train (no date). Available at: https://financetrain.com/calculating var using historical simulation/ (Accessed: 18 May 2020).

CHAPTER 8 MANAGEMENT OF TRANSACTION EXPOSURE SUGGESTED ANSWERS AND SOLUTIONS TO END OF CHAPTER QUESTIONS AND PROBLEMS QUESTIONS 1. How would you define transaction exposure? How is it different from economic exposure? (no date).

Currency Forward Definition (no date). Available at: https://www.investopedia.com/terms/c/currencyforward.asp (Accessed: 18 May 2020).

Currency Option Definition (no date). Available at: https://www.investopedia.com/terms/c/currencyoption.asp (Accessed: 18 May 2020).

Foreign exchange option Wikipedia (no date). Available at: https://en.wikipedia.org/wiki/Foreign_exchange_option (Accessed: 18 May 2020).

Forward Contracts (no date). Available at: https://kfknowledgebank.kaplan.co.uk/forward contracts (Accessed: 18 May 2020).

Historical VaR — Northstar Risk (no date). Available at: https://www.northstarrisk.com/historical var (Accessed: 18 May 2020).

How Forward Contracts Hedge Risk in Foreign Markets | Study.com (no date). Available at: https://study.com/academy/lesson/how forward contracts hedge risk in foreign markets.html (Accessed: 18 May 2020).

How the Money Market Hedge Works (no date). Available at: https://www.investopedia.com/articles/forex/020414/money market hedge how it works.asp (Accessed: 18 May 2020).

How To Use A Forex Hedging Strategy To Attain Low Risk Profits (no date). Available at: https://admiralmarkets.com/education/articles/forex strategy/how to use a forex hedging strategy to look for lower risk profits (Accessed: 18 May 2020).

International Financial Management Thummuluri Siddaiah Google Books (no date). Available at: https://books.google.com.pk/books?id=0XllKAoOES8C&pg=PA179&lpg=PA179&dq=Relationship+between+the+Payoff+and+Profit+and+Future+Spot+Exchange+Rate+of+Money+Market+Hedge+Strategy:&source=bl&ots=9hErshURWo&sig=ACfU3U2VHaBRHdanPjV8QCmLBNNVa_0CJg&hl=en&sa=X&ved (Accessed: 18 May 2020).

Money Market Hedges (no date). Available at: https://kfknowledgebank.kaplan.co.uk/money market hedges (Accessed: 18 May 2020).