Foreign Exchange Risk Management in the United States


Introduction


            The provisions of many authors on valuable analysis of the foreign exchange market of the United States had been widely appreciated by interested persons in gaining deeper understanding of the situation.  However, findings on a certain U.S. market condition in the 1980s and 90s would be totally different from the present-day.  Foreign exchange market is always changing, always adapting to a shifting world economy and financial environment.  Thus, it would be very useful to reexamine the foreign exchange market of the U.S. from today’s perspective.  The foreign exchange business is by its nature risky since it deals principally in risk – measuring it, pricing it, accepting it when appropriate, and managing it.  The success of a bank or other institution trading in the foreign exchange market depends critically on how well it assesses, prices, and manages risk, and on its ability to limit losses form particular transactions and to keep its overall exposure controlled ().


 


Managing Market Risk


            Various mechanisms are used to control market risk, and each institution will have its own system.  At the most basic trading room level, banks have long maintained clearly established volume or position limits on the maximum open position that each trader or group can carry overnight, with separate – probably less restrictive – intraday or “daylight” limits on the maximum open position that can be taken during the course of a trading session.  These limits are carefully and closely monitored, and authority to exceed them, even temporarily, requires approval of a senior officer.  In a report of the Group of Thirty entitled Derivatives: Practices and Principles, industry members recommended a series of actions to assist in the measurement of market risk.  They recommended that institutions adopt a “value at risk” (VAR) measure of market risk, a technique that can be applied to foreign exchange position resulting form the totality of the bank or firm’s activities. 


            VAR estimates the potential loss from market risk across an entire portfolio, using probability concepts.  It seeks to identify the fundamental risks that the portfolio contains, so that the portfolio can be decomposed into underlying risk factors that can be quantified and managed.  Employing standard statistical techniques widely used in other fields, and based in part on past experience, VAR can be used to estimate the daily statistical variance, or standard deviation, or volatility, of the entire portfolio.  On the basis of that estimate of variance, it is possible to estimate the expected loss from adverse price movements with a specified probability over a particular period of time (usually a day).  Consequently, a bank might want to calculate the maximum estimated loss in its foreign exchange portfolio in one day from market risk. 


            After a generation of revolutionary change in the global foreign exchange market, the question arises, where does that market go from here?  What changes can we expect in the future?  In some areas, we can point to emerging trends and possible directions. 


Global Financial Trends


            There is little evidence that the evolution of the world economy toward deregulation and global integration is ending, and little reason to expect that the powerful forces that are moving us in those directions will stop suddenly.  International trade continues to grow robustly, and international financial transactions and investment far more so.  In the United States and many other countries, managed funds are still very heavily invested in domestic assets, which suggest that there is plenty of room for further shifts abroad.  Even modest increases in the tendency to look across borders, toward other countries and other currencies for investment opportunities, can have significant implications for levels of activity in the foreign exchange market.


Introduction of the Euro


            In Europe, the move to a single currency – the euro – for participating European Community members is expected to reduce global foreign exchange trading below what it would otherwise be.  Indeed, the savings from not having to convert from one member country’s currency to another are one of the advantages, or efficiencies, expected from the move to a single currency.


Increased Trading in Currencies of Emerging Market Countries


            There are estimates that the introduction of the euro may result in a level of global foreign exchange transactions about 10 percent lower than otherwise. 



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