Magazine article Business Credit

Using FX and Interest Rate Derivative Markets to Manage Risk

Magazine article Business Credit

Using FX and Interest Rate Derivative Markets to Manage Risk

Article excerpt

The derivatives markets are undoubtedly the most traded of any financial market. The volume in foreign exchange (FX) alone is 40 to 50 times the size of the U.S. stock market on any given day. And the impact of FX and interest rate movements has vital implications for economic growth, inflation and, accordingly, corporate profitability across all industries.

The current global environment is particularly interesting. For the first time in nearly a decade we are seeing interest rates rise in the U.S. Both the U.S. and U.K. have had significant political regime changes, and other European countries will go through election phases this year. Finally, the global trade landscape is shifting based on policy proposals coming out of the U.S., which may have huge implications for FX. All of these factors create a heightened sense of risk and the potential for significant volatility.

Changes in FX and interest rates can benefit some economic constituents tremendously and be devastating to others. For example, a strong dollar benefits the consumer through lower inflation but hurts exporting companies who sell in foreign currencies. Interest rates present an even simpler example, as higher rates benefit lenders but increase the cost for borrowers. From a macroeconomic perspective, central banks have to strike a balance between raising rates to stem inflation and lowering rates to stimulate growth. Clearly, winners and losers are created when the FX and interest rate markets move.

From Macroeconomic to Microeconomic

Companies see the impact of these markets in several ways, some short term in nature and others long term. A company that borrows floating-rate debt would see a relatively immediate impact in interest expense and cash flow if interest rates rise. On the other hand, a company with fixed-rate debt would not typically recognize the effect of higher rates until the debt needs to be refinanced, at which point the new debt will carry a higher interest rate. Therefore, the impact of higher rates eventually impacts this company as well.

Foreign exchange exposure also results in short-term and long-term implications. Companies that buy or sell product outside of the U.S. often have to buy or sell other currencies. Consequently, foreign costs and revenues fluctuate with the value of the dollar. And since most companies that operate globally plan to do so into perpetuity, the exposure to FX is both immediate and ongoing.

Ultimately, these global risks cannot be eliminated, but they can be managed.

Assessing Risk and Setting Goals

To manage the risk, companies often need to hedge with derivatives. No single approach to hedging will make sense for all companies at all times. Each company should evaluate how FX and interest rates impact overall corporate risk. This process is not always as simple as looking at one risk factor and then trying to mitigate that risk. A best practice in assessing risk involves quantifying multiple factors and determining how these factors contribute to the total picture.

To evaluate FX risk, many companies use a value at risk (VAR) model to look at all of their currency exposures and the historical correlation of those exposures. Sometimes the "risk" of one currency offsets the "risk" of another such that the company has a natural hedge. …

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