4-minute read
In a previous article (here), we explained the basics of mark-to-market valuations, collateral for hedging, and margin calls.
In this article, we'll introduce the concept of sensitivity analysis of derivatives valuations and why it's important to know your portfolio MTM value against changes in the underlying exchange rate.
Valuable Insights
We've already established that after a currency hedge has been entered, fluctuations in the underlying exchange rate change the value of the position. This change in valuation brings about cash flow risks to the buyer, chiefly margin calls.
It's handy to know the extent, and to be able to quantify the position value for various spot rate movements:
- To know when you will incur a margin call
- Understanding the rate beyond which your credit limit is fully utilised
Easy Example
A UK business with costs in US dollars has five forward contracts in place to mitigate their currency risk: they Sell GBP to Buy USD.
For the sake of this example, we'll ignore the contract maturity dates, although in reality this is vitally important. Why? Because the revaluation process uses the forward rate to the maturity date of each contract, not the spot rate. Using the spot rate would produce wildly inaccurate and unreliable outputs!
Valuing forward contracts is simple. Let's use Contract 1 as an example:
- Contract 1, Sell GBP 1,000,000 at $1.2852, buying USD 1,285,200
- Assuming a Revaluation Rate of $1.2190
- USD 1,285,200 / 1.2852 = GBP 1,054,306
- Contract 1 value is £54.3k (In The Money)
💡 Take care to produce the correct sign (+/-) for Sell and Buy contract directions. If Contract 1 was a Buy GBP trade, the valuation would be -£54.3k – it would cost more GBP to purchase the USD to unwind/close the contract.
Here I've produced a table of +/- 20% MTM valuations for each contract in 5% increments. We can see how each contract changes in value and the net position (which is the important bit) is shown in the final row and the accompanying chart.
Again, as these contracts are all Sell GBP, they move into negative value ("offside", Out of The Money 'OTM') when the revaluation rate is higher than the contract rate and vice versa for the downside/ITM.
Do you know your position value?
It's very important that you know and understand your hedging position value, otherwise you'll be surprised by those pesky margin calls.
When your FX consultant, bank, or broker is preparing a risk management strategy for you, they should make it very clear how the trade(s) will perform in terms of MTM.
Want to know more?
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We give live position value and collateral management via our online platform, so you can always manage your positions and there will never be any surprises!
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 👋
