What Can FX Risk Management Models Achieve?
by Martin Winkler, Managing Partner, Schwabe, Ley & Greiner
The cancellation of the – supposedly – guaranteed CHF/EUR minimum exchange rate by the Swiss National Bank (SNB) has once again made clear what risk management means: preparing for unlikely events. The cancellation of the minimum exchange rate was such an event: unlikely, however not impossible to occur.
As we can see from the past, something like this happened before as Figure 1 shows (below).
In risk management, unlikely events should be considered and calculated by way of stress tests. These are indispensible when the question arises of how much risk the company can bear. A stress test focuses on highly adverse movements of past market prices or on movements that have never occurred before. Stress tests should be conducted regularly and the parameters should be scrutinised as well.
Apart from the stress tests, it is important to constantly observe the development of the FX risk. It is not enough merely to look at the shift in parity as required by IFRS. In addition, possible fluctuations in market price should be included. These fluctuations are expressed statistically by the size of the volatility. Volatility is accordingly taken into account in the at-risk models. Consequently these models are significantly more powerful than the popular sensitivity analyses.
The CHF/EUR event in mid January raises the need to critically question the input factors of the at-risk calculations: do we use historical (calculated from historical data) or implicit (traded) volatilities? A final answer cannot be given here, though we recommend always looking at and interpreting both ways.
After the introduction of the CHF minimum exchange rate in 2011, historical and implicit volatilities were lower than before – but not lower than before the financial crisis in 2008, when there was no guarantee for a minimum rate (see Figure 2).
The volatilities clearly show the FX risk before and after the financial crisis. The implicit volatilities prove that doubts in the apparent stability of the minimum exchange rate existed already months before its abolishment in January 2015 (see increase as from September 2014).