4-minute read
Backtesting is an important and widely adopted practice in the investment community, but for business currency risk management it's not as common as it might be. In this article, we'll look at the pros and cons of backtesting a currency hedging strategy and explain how we use this process at Oku Markets.
Important but overlooked?
Backtesting is the analytical process of applying trading or hedging strategies against historical market data (FX prices) to test and compare the performance and outcomes against a set of criteria.
The process is fairly labour intensive and requires what-if analysis on every hypothetical trade. Access to huge amounts of market data is essential, as is the expertise and the capabilities to process and crunch the numbers.
Most FX brokers don't backtest their recommendations because it's time-consuming and complex, and they lack the skills and expertise to do it. Unfortunately, this means their clients are missing out on a comprehensive and detailed analysis that aids decision-making.
Harry Mills, Founder & CEO Oku Markets
Eyes on the Prize
It's very important to have a set of criteria – hedging objectives – to analyse and compare the performance of any strategy against. Placing a currency hedge can, in the simplest form, result in a binary outcome when compared exclusively against the underlying spot rate. Market goes up, therefore... Market goes down, therefore... You get the idea...
...If a UK company is a net importer with costs in euros, then of course if the pound strengthens versus the euro over the test period the solution with the benefit of hindsight might be "do nothing," and any hedges would likely perform poorly against the spot rate. The opposite is true if the pound were to fall over the test period.
So we need to be careful about our objectives – here are some easy ideas:
- Limit downside risk by X (there's a trade-off in upside, which must be acceptable)
- Reduce realised exchange rate volatility by X
- Achieve a pre-determined budget exchange rate (or better)
- Protect gross margin of X
- Reduce trading costs by X
What about other objectives, perhaps less easy to quantify?
- Remain competitive should the market move favourably
- Reduce FX admin (hedging decisions, sticking to a policy, removing gut calls)
- Improve the certainty of future cash flows
- Maintain a 75% hedge ratio across 6 months (certainty, buying time)
- Not to increase customer pricing
Pros and Cons
The primary advantage of backtesting a hedging strategy is to understand how it would have performed in various historical market scenarios. The quantitative outputs of the analysis (P&L, for example) are the main points of interest, but having a real-life example, and the accompanying charts and dataset, helps businesses to visualise and understand a hedging strategy concept.
Being able to assess what would have happened gives rise to further discussion points – the more qualitative elements. Would demand have been affected? Would we have changed our prices? Would we be happy with that outcome? Is the protection/participation trade-off appropriate? Would this have prevented problem X from occurring? And so on...
The disadvantages are fairly obvious, but here's a summary:
- It's difficult to avoid biases (confirmation bias, look-ahead bias)
- Backtesting usually requires a fairly rigid setup, for example, "trade every Thursday", which might not be representative of reality
- The test doesn't cover all market conditions and possible extreme events
How we Backtest
- Keep it simple – back-test against the last Financial Year or a few recent years
- Ensure to fit the strategy around the needs of the business e.g. weekly payments
- Set clear objectives and criteria for measurement
- Test several strategies, borrowing from the FX risk toolkit (layered, rolling etc.)
- Explain the setup e.g. weekly trading, every Thursday
- Explain the limitations of the test
- Consider the results in relation to VaR and Stress Testing analytics
The backtest is used to inform the next discussion and to set sensible parameters for a forward-looking hedging programme e.g. maintaining some flexibility about when to trade at each interval (say within a 2-3 day range) and setting a min/max hedge amount to allow some opportunistic trading if appropriate.
💡Remember: there is no magic bullet or one-size-fits-all approach!
Need our Help?
You can contact us for a review of your currency processes and for our guidance and suggestions at [email protected] or 0203 838 0250.
Thanks for reading 👋
