Why do folks go to burger joints? I suppose one obvious answer is for burgers. However, that’s not the only reason, right? It’s also to socialise, to chat with your friends and family. Otherwise, you might just choose to sit at home and make your own burger (or at these point for lockdown reasons). Or perhaps it’s to have a better burger than you might be able to have at home and to socialise. It’s not exactly a difficult question, but what is clear, is that there isn’t a single answer. Everyone has different motivations and objectives.
In financial markets, it can be tempting to think that everyone is basically a speculator and wants to make money. Ok, no one really aims to lose money when trading, but it isn’t the case that everyone is a speculator. Equities markets are there for corporates to raise funding to plough back into their primary business (which in most cases isn’t financial markets). Fixed income markets are there for all sorts of entities to borrow money, whether it is corporates or sovereigns. When it comes to foreign exchange markets, corporates trading across borders have to trade. They will need to pay expenses abroad, they will need to repatriate revenue etc.
Each corporate will have a different approach to FX and how their FX is hedged. Let’s say a USD based corporate is expecting revenue of 1bn MXN in the next year in Mexico. This is effectively like having short USD/MXN exposure. Assuming there’s no FX hedge, if MXN appreciates throughout the year, happy days! However, if it weakens it has exposed the company to a loss, which could be significant.
If mandate may say that a treasury team should immediately hedge that FX risk. This hedge could involve entering into a long USD/MXN trade in the full amount (ie. 1bn MXN), to net out our exposure to flat. This trade will clearly reduce the risk (and hence a potential loss), but it’ll be costly, given that historically Mexican interest rates are much higher than US rates, hence you’d be short carry. Others will get some discretion of how much risk they hedge, within some predefined parameters. There is also a question of what type of instrument they should use to hedge, would a spot/forward be best, or can they use an option? When I say “option” I don’t mean some funky structure which has a very chunky bid/ask spread, and the risks might be tricky to understand, but something like a call or put, or a spread. Just like any trader, corporates need to be able to understand their transaction costs when executing FX, and indeed, I’ve developed tcapy a free open source to do this!
I’m currently doing a joint project with Paul Bilokon and Thalesians to build a tool for treasury desks to understand their FX exposure and to help manage it. So far we’ve worked mostly on functionality to calculate FX VaR using a number of different methods, to work out optimised hedge ratios etc. At present the front end is in Excel. However, the backend is written in Python and parts of the code is optimised to make it quick, in particular to ensure that Monte-Carlo simulations are fast (and a whole lot faster than attempting to try to do all the calculations in Excel too!). We’re looking to add new features to the tool and if you’re a corporate who would be interested to chat to Paul and I about this new tool, let us know! It’s still in the early stages, and we’d love to add features which you folks really need.
Not everyone is trading FX or financial markets to make money, often they need to be involved in these markets as part of their main business. But that doesn’t mean they should lose money in the process too, and they should have the tools to manage the risk effectively. Hopefully, we’re on that path to helping out with tools!