Question 1
Standard deviation and value at risk (VaR) are statistical models that are widely used to measure the risk of a portfolio or an asset.
Discuss how the use of such statistical models could result in the actual losses being far greater than that predicted under the models.
Economic theory says that price differences between countries should narrow over time and that supply and demand for currencies will come into equilibrium in the long run. Hedging is therefore a trivial and pointless pursuit by corporates. Discuss.
The basic advantage of a currency swap is that it provides the firm long-term hedging cover against exchange rate risk by adding liquidity and contributing to the development of long-term forward markets for the major trading currencies.
- Although swaps have many advantages explain them and discuss the potential problems or drawbacks in utilizing currency swaps.
- Explain the operation and mechanics of a sterling/euro swap.
Question 1.
It is necessary to apply VAR when the loss functions aren’t normally distributed to produce the estimations. Because the bulk of the distributions is fat-tailed, the VAR model might suffer far greater losses in agricultural production than other models, compared to other models.
The most serious fault with VAR is that it provides the user with a false sense of security. You can be confident that your results will be accurate 99.5 percent of the time if you use VAR to calculate them. There is, however, a possibility that part of the model will result in a loss because 99 percent of the time is not precisely the same as 100 percent of the time. To put it another way, placing too much trust on VAR can result in catastrophic losses.
VAR does not account for the worst-case scenario. When set to 99 percent, the application does not indicate the magnitude of the anticipated loss (1 percent about 2-3 days every year). This may appear to be a modest proportion, yet it may be sufficient to liquidate a business. As this constraint is disregarded, it can result in significant losses when compared to comparable programs.
Due to VAR’s inability to handle big volumes of data, it is difficult to compute large portfolios with it. To calculate VAR, one must first ascertain the degree of correlation between the returns and volatility of various assets in a portfolio. As the portfolio expands in size and variety, the amount of effort associated with running this firm on a day-to-day basis increases proportionately. Due to its ease of neglect, this frequently results in major losses.
The absence of the additive nature of VAR makes it liable to losses. Because of the relationships that exist between the various risk indicators, VAR is more than just a sum of the individual risk indicators. The total of the VARs for each asset in a portfolio that comprises both A and B is not equal to the sum of the VARs for each asset in the portfolio.
The quality of VAR’s output and utility is only as good as the data that is fed into it. When using the classic variance-covariance VAR approach, it is common to make the mistake of assuming a normal distribution of returns in the presence of non-normal skewness and excess kurtosis. The use of exaggerated return distributions as inputs to VAR may result in an underestimation of the true risk in the VAR model. This under or overestimation often leads to great losses when not taken into consideration.
Question 2
Value at Risk (VAR) can be determined in a variety of ways, including the standard variance-covariance parametric VAR, the historical VAR approach, and the Monte Carlo VAR methodology. It’s advantageous to have a range of alternatives, as different strategies perform better in different situations. On the other hand, VAR may be questioned, as different strategies might provide fairly disparate results for the same portfolio. This can lead to great losses if they are not well applied.
Question 2.
A risk management strategy known as hedging entails taking an opposite position in a comparable asset to offset investment losses. The risk reduction achieved by hedging typically leads to a decrease in expected earnings. When the price between countries narrows, supply and demand for currencies will come into equilibrium. This will make Hedging a pointless pursuit because all the sides will have the risks distributed equally.
A forward contract is when a business contract to buy a specified quantity of currency at a predetermined exchange rate in the future. By entering into a forward contract, a firm may ensure that a certain future responsibility can be satisfied at a specified exchange rate. A customized contract enables accurate currency hedging. Due to the comparable exchange rates, this will be a pointless exercise when an equilibrium demand and supply of currency.
When the value of a currency is balanced, the risks are evenly dispersed, and as a result, the currency option that permits a person or a firm to sell an asset at a specific period will no longer be effective. It is not in the best interests of the corporation to relocate its assets to a foreign nation. Corporations will not have the liberty of reducing their risk by hedging their businesses.
The main aim of hedging is to avoid the fluctuations that may arise. Floating exchange rates, the norm in most major economies, inevitably lead to currency swings. One of the most important influences on currency exchange rates is the country’s economic performance, its inflation prognosis, and so on. The strength and weakness of the underlying economy often determine the exchange rate of a currency. That’s why currency values are subject to rapid shifts. When there is an equilibrium in supply and demand, these factors will not affect hedging either way.
A reduction in taxes will not be achieved owing to the balance between demand and supply for money. As a result, the tax burden on each individual will be roughly equivalent to what it would have been if they had not hedged. Insurance premiums for some company insurance plans are tax-deductible, therefore obtaining insurance can reduce predicted taxes.
Hedging against investment risk is the process of using financial instruments or market strategies to reduce the chance of losing money if a stock’s price drops unexpectedly. Another way of putting it is that investors hedge their chances by holding a position in a different type of asset. Hedging, according to its technical definition, is the execution of counter-moving trades in assets that have minimal connection to one another in price. Health insurance is an inescapable expenditure that cannot be avoided, regardless of how you choose to pay for it. Consider the following scenario: if you are a long XYZ company, you may want to consider acquiring a put option to protect your investment: When the demand and supply of a currency are equal, hedging is not an option for lowering the risk of an investment.
Question 3a
There are various advantages to employing currency swaps, but there are also some potential disadvantages to using currency swaps as well. Currency volatility is a risk that must be considered when converting between currencies.
Furthermore, this affects everyone, not just those who deal in the currency markets. Currency fluctuations have the potential to significantly reduce the profits of a successful foreign companendeavour or even wipe out the whole value of a portfolio with significant international exposure. To avoid currency risk, companies that do business across borders must ensure that their revenue and payments are made in the currency of their home nation, and vice versa.
Finding a willing counterparty is one of the costs associated with a foreign currency swap. Negotiation with the other party or with a mediator is a possibility. The method may be costly in terms of intermediary costs or management time spent in discussions. The legal fees for preparing the currency exchange agreement will also be incurred. As a short-term currency hedge, currency exchange may not be cost-effective. In the long term, when there is more risk, the swap may be cheaper than other derivatives. There is a risk that the other party will not keep their half of the arrangement.
There is a possibility of the other side defaulting. While cross-currency swaps offer several benefits, they also present a new form of risk. If the swap counterparty defaults on their payments, the borrower will be unable to repay the loan. Cross-currency swaps involving a swap bank can conduct a detailed analysis of the parties’ creditworthiness and ability to pay their commitments, therefore mitigating this type of risk.
Question 3b.
With a total market value of around $1 trillion, the euro interest rate swap market is one of the largest and most liquid financial markets in the world, ranking it among the most liquid in the world. The swap curve is gradually becoming the most important yield curve in the euro financial markets, and it is already being used as a benchmark to evaluate individual government bonds, according to the Financial Times.
Despite the fact that the euro bond and loan markets had tremendous growth, the euro swap market experienced even greater growth. Following the introduction of the euro, there was a significant increase in the issuance of euro-denominated bonds, which in turn stimulated arbitrage and hedging operations amongst issuers, dealers, and investors.
Non-government bond investors began using interest rate swaps to hedge their holdings in the early 1990s, some years before investors in the United States currency and other financial markets. With the increase in hedge and position activity, the euro swap market has seen its size increase. Following the establishment of the European Monetary Union, swaps swiftly surpassed some of the traditional currency benchmarks to become the most important source of information regarding future short-term interest rates, eventually displacing them entirely.
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