A portfolio is a set of assets, in this case, the portfolio comprises of 10,000 and 5,000 Japanese Yen Swiss Franc respectively. The rate of exchange for the two are USD/JPY 100 and USD/CHF = 1.0 Therefore, the portfolio will contain the following dollar amounts.
10,000 JPY/100 = $100
5,000 SWISS Franc /1 = $5,000
The returns of the currencies for the period is then calculated which is then multiplied by the portfolio values to give the daily portfolio return which is then used to calculate the Value at risk (VAR) as shown below
The table below shows the exchange rates between 16th and 31st
December 2013 according to the Federal Reserve (Fed, 2018).
Date
YEN
FRANC
Returns YEN
Returns Franc
31-Dec-13
0.009501
1.123091
-0.24%
-0.43%
30-Dec-13
0.009524
1.127904
0.05%
0.30%
27-Dec-13
0.009519
1.12448
-0.31%
0.79%
26-Dec-13
0.009549
1.115698
-0.44%
-0.02%
24-Dec-13
0.009591
1.115947
-0.19%
-0.21%
23-Dec-13
0.00961
1.118318
0.01%
0.11%
20-Dec-13
0.009609
1.117069
0.09%
0.13%
19-Dec-13
0.009601
1.115573
-0.94%
-1.03%
18-Dec-13
0.009692
1.127142
-0.53%
-0.02%
17-Dec-13
0.009744
1.127396
0.27%
0.07%
16-Dec-13
0.009717
1.126634
VAR Historical Simulation for a portfolio
YEN
FRANC
Portfolio(amount in dollars)
100
5,000
Value at risk (VAR) @95%
-38.4508
DATE
YEN
FRANC
YEN
FRANC
Portfolio
31-Dec-13
-0.24%
-0.43%
-0.24
-21.34
-21.58
30-Dec-13
0.05%
0.30%
0.05
15.23
15.27
27-Dec-13
-0.31%
0.79%
-0.31
39.36
39.04
26-Dec-13
-0.44%
-0.02%
-0.44
-1.12
-1.55
24-Dec-13
-0.19%
-0.21%
-0.19
-10.60
-10.79
23-Dec-13
0.01%
0.11%
0.01
5.59
5.60
20-Dec-13
0.09%
0.13%
0.09
6.70
6.79
19-Dec-13
-0.94%
-1.03%
-0.94
-51.32
-52.26
18-Dec-13
-0.53%
-0.02%
-0.53
-1.13
-1.66
17-Dec-13
0.27%
0.07%
0.27
3.38
3.66
VAR is a method of calculating risk. Variance is also used to calculate risk, but it does not care about the direction an investment movement hence the introduction of VAR. VAR is based on the notion that investors risk is about the odds of losing money, hence with this assumption, it answers the question of how much money an investor will lose in a given period in the worst case scenario. The above calculated VAR of -38.4508 shows that having invested 10,000 YEN and 5,000 Swiss Franc, I am at 95% confident that the worst daily loss will not exceed $38.4508. The total returns of the portfolio are negative which is not preferable. The negative returns are caused by the exposure to exchange rate risk which can be explained and mitigated as below.
Exchange rate risk exposure
Exchange rate risk is an unavoidable risk of investing in the foreign markets. The goal of every investor is to maximize returns while minimizing the risk. Although when the risk is high, the returns tend to be higher, if the risk goes against your investment, incurs losses. The risk, however, can be mitigated using hedging methods. Portfolio investment is a model of foreign investment that is also known to reduce risk since it implies having a pool of different assets such that when one asset is making losses, the other is making profits hence reducing risk. The general rule in investing is that when the home currency is devaluing against the foreign currency, unhedged the risk but hedge risk when it appreciates. There are many ways through which one can mitigate risk.
Methods of hedging risk
There are several methods through which an investor can hedge assets to ensure they earn the highest level of returns.
Investing in hedged assets.
One of the easiest options for an investor who wished to hedge against foreign risk is to purchase hedged overseas assets. Examples of such assets are hedged exchange-traded funds (ETFs). There are accessible EFTs for many underlying assets that are merchandised in major markers. Although the hedged funds have a marginally higher cost ratio, than the unhedged assets, their currency risk is lower.
Hedging the exchange rate risk yourself
The other option in hedging risk apart from buying hedged assets is hedging the currency risk by yourself. Investors can hedge risk on their own using the following instruments for hedging currency risk.
1. Currency Forwards
Currency forwards are contracts that have a defined exchange rate for a specified date in future. The contract acts as a hedging tool that does not require the investor to pay any upfront payment (Jacque, 2013). One the greatest benefits of such a contract is that it can be custom-made to a certain quantity and delivery date, unlike standardized currency futures. The settlement for the agreement can be made on a cash on delivery basis so long as the option is accepted by both parties and has been specified before the delivery date. There are over the counter currency forwards that are traded on the open market as opposed to the centralized exchange.
2. Currency ETFs
When there are available ETFs that have a particular currency as the underlying assets, it implies that the ETFs can be used to minimize risk (Hill et al., 2015). Since this portfolio is composed of Japanese Yen and Swiss Franc, currency EFTS for both currencies are readily available. Therefore, to minimize the risk exposure of this portfolio, I will use currency ETFs.
3. Currency options
A currency option is an agreement between two parties whereby one party is the buyer while the other is the seller (Shiraya & Takahashi, 2014). The purchaser has the right but not a responsibility to trade a specified currency at a stated rate on a specified date. The seller then pays a premium to have the right which is an amount that varies depending on the number of contracts.
In addition to hedging, investors can minimize foreign currency exchange risk using the following methods. First is by shorting an overvalued currency. It is advisable to short currencies which are expected to fall in value. In this case, the investor will sell the currency at a prearranged price on a particular date in future. Since every currency sells in a pair, when shorting a currency, one must purchase another currency for the transaction to be completed. The second option for an investor to minimize risk is looking for high-interest rates. By purchasing a currency of a nation that has a higher interest rate than America’s one is in a better position to minimize risk and earn returns. The strategy is only used when it is believed that the nation’s rate can be constant at its present level. The last strategy is to buy undervalued currencies. A currency is undervalued if the county has a current account deficit and inflation differentials
References
Fed. (2018). The Fed - Foreign Exchange Rates - H.10. Retrieved from https://www.federalreserve.gov/releases/h10/Hist/dat00_sz.htm
Hill, J. M., Nadig, D., & Hougan, M. (2015). A comprehensive guide to exchange-traded
funds (ETFs). Research Foundation Publications, 2015(3), 1-181.Hoyle, J. B., Schaefer,
Jacque, L. L. (2013). Management and control of foreign exchange risk. Springer Science
& Business Media.
Shiraya, K., & Takahashi, A. (2014). Pricing Multiasset Cross‐Currency Options. Journal
of Futures Markets, 34(1), 1-19.
