Trading is the exchange of goods or services between two or more parties. So, if you need gasoline for your car, then you would trade your dollars for gasoline. In the old days, and still in some societies, trading was done by barter, where one commodity was swapped for another.
A trade may have gone like this: Person A will fix Person B’s broken window in exchange for a basket of apples from Person B’s tree. This is a practical, easy to manage, day-to-day example of making a trade, with relatively easy management of risk. In order to lessen the risk, Person A might ask Person B to show his apples, to make sure they are good to eat, before fixing the window. This is how trading has been for millennia: a practical, thoughtful human process.
Making money off the difference between the values of currencies “foreign exchange” or “forex” trading isn’t for the faint of heart. For one thing, there are no centralized markets like the stock exchanges to facilitate your trades. For another, the risks go well beyond an individual companies, or an entire industry’s, performance. However, if you understand the risks, and trade conservatively, you can effectively trade currencies.
Risk in Forex Dealing
Foreign exchange risk, also known as exchange rate risk, is the risk of financial impact due to exchange rate fluctuations. In simpler terms, foreign exchange risk is the risk that a business’ financial performance or financial position will be impacted by changes in the exchange rates between currencies.
Types of Foreign Exchange Risk
The three types of foreign exchange risk include:
Economic risk, also known as forecast risk, is the risk that a company’s market value is impacted by unavoidable exposure to exchange rate fluctuations. Such a type of risk is usually created by macroeconomic conditions such as geopolitical instability and/or government regulations.
For example, a Canadian furniture company that sells locally will face economic risk from furniture importers, especially if the Canadian currency unexpectedly strengthens.
Transaction risk is the risk faced by a company when making financial transactions between jurisdictions. The risk is the change in the exchange rate before transaction settlement. Essentially, the time delay between transaction and settlement is the source of transaction risk. Transaction risk can be mitigated using forward contracts and options.
Translation risk, also known as translation exposure, refers to the risk faced by a company headquartered domestically but conducting business in a foreign jurisdiction, and of which the company’s financial performance is denoted in its domestic currency. Translation risk is higher when a company holds a greater portion of its assets, liabilities, or equities in a foreign currency.
For example, a parent company that reports in Canadian dollars but oversees a subsidiary based in China faces translation risk, as the subsidiary’s financial performance which is in Chinese yuan is translated into Canadian dollar for reporting purposes.
Using leverage in forex trading isn’t all that different from using it with stocks and options. When you trade on margin, you borrow money from your broker to finance trades that require funds in excess of your actual cash balance. If your trade goes south, you might face a margin call, requiring cash in excess of your original investment to come back into compliance.
While leverage can exponentially increase profits, it can do the same with losses. Currency markets can be volatile even small price shifts can trigger margin calls. If you’re heavily leveraged, you might face substantial losses. If you’re a novice trader, consider the major risks of trading on margin before borrowing from your broker.
Measure of Value at Risk
Value at risk (VaR) is a statistic that quantifies the extent of possible financial losses within a firm, portfolio, or position over a specific time frame. This metric is most commonly used by investment and commercial banks to determine the extent and probabilities of potential losses in their institutional portfolios.
Risk managers use VaR to measure and control the level of risk exposure. One can apply VaR calculations to specific positions or whole portfolios or use them to measure firm-wide risk exposure.
VaR modelling determines the potential for loss in the entity being assessed and the probability that the defined loss will occur. One measures VaR by assessing the amount of potential loss, the probability of occurrence for the amount of loss, and the timeframe.
A financial firm, for example, may determine an asset has a 3% one-month VaR of 2%, representing a 3% chance of the asset declining in value by 2% during the one-month time frame. The conversion of the 3% chance of occurrence to a daily ratio places the odds of a 2% loss at one day per month.
Using a firm-wide VaR assessment allows for the determination of the cumulative risks from aggregated positions held by different trading desks and departments within the institution. Using the data provided by VaR modelling, financial institutions can determine whether they have sufficient capital reserves in place to cover losses or whether higher-than-acceptable risks require them to reduce concentrated holdings.
There are three main ways of computing VaR. The first is the historical method, which looks at one’s prior returns history and orders them from worst losses to greatest gains following from the premise that past returns experience will inform future outcomes.
The second is the variance-covariance method. Rather than assuming the past will inform the future, this method instead assumes that gains and losses are normally distributed. This way, potential losses can be framed in terms of standard deviation events from the mean.
Despite being widely used, VAR suffers from a number of drawbacks. Firstly, while quantifying the potential loss within that level, it gives no indication of the size of the loss associated with the tail of the probability distribution out of the confidence level. Secondly, it is not additive, so VAR figures of components of a portfolio do not add to the VAR of the overall portfolio, because this measure does not take correlations into account and a simple addition could lead to double counting. Lastly, different calculation methods give different results.