Modeling Foreign Exchange Risks The economy of the world todays is open to free trade.

The basic reason that led the habitants of different continents to come together is trade and the benefit that accrue from them.But todays trade is not that simple. As the economies progressed, the trade and the principles that directs the trade also got complex. One of those factors is the foreign exchange. Unlike old days where trade was done on the basis of barter or in exchange of real monies such as gold and silver, the trade todays is based on paper currencies and electronic money. As there are disparity in the economic conditions of different economies there currency cannot be valued on the same standard. For example say the value of a United States Dollar cannot be the same as a Kenya Shilling as they belong to and represents the confidence of different economies. It is a well understood fact that value paper currency unlike real money is directed by the confidence that one places on the economy it belongs to. It can viewed in similar context to a promissory note, the value of which is directed by the confidence one places on the capacity of the drawer to honor the same. So the basic question is how to model this risk in such a way that the exposure of a user is minimized. The problem here is that foreign exchange rates are subject to many factors that reacts independently and dependently in a random fashion with one another. The methods to model such risk in use are complex and one needs to hire good consultants to make sure that they get these right. In this paper our efforts are to try and achieve a very simple approach to model foreign exchange risks. Though in the latter parts we would also shed some lights on the more complex issues in relation to foreign exchange but it is advised that people who are not so comfortable with mathematical notations keep themself away from those parts. Now the first step towards understanding foreign exchange risk one should understand the modeling of foreign exchanges itself. For this we will make some very seely assumptions which will apparently look mischievous but they will be well suited for understanding and are fully relevant to the real world situations. Our first assumption is that there are only two countries in the world, say INDIA and USA. These two countries are producing only two commodities each. One commodity is common to both of them while the other is unique in both countries. Say INDIA produces C1(Common Commodity) and X(Unique) and USA produces C1 and Y. So when they first try to make an exchange in terms of RUPEES PER UNIT OF DOLLAR at what price they would have agreed. Say the price of Common Commodity in INDIA was 10 RUPEE and in USA was 2$ then is the two currency on same footing. The answer is NO, the amount of sacrifice one need to purchase the same thing is more in quantitative terms in INDIA in comparison to USA. There may be many factors that may result in such price disparity between same commodity in two different countries such as Availability, Technology, Capital, Labor, Regulations and Governance etc. But they must need some scale to measure the paper currency. So they would agree on such a price that no one looses. Thus the price will be 1 DOLLAR is equal to 5 RUPEE. This is the initial price on which trade starts. Thus they will always change with change in the Inflation of the economies. Say if after one year if no other factors changes the price of DOLLAR then if the price of C1 is 2.5$ keeping the price in INDIA constant, is 4 RUPEE. So clearly the factor of INFLATION influences the rates greatly. The underlying principle here is PURCHASE

PRICE PARITY. If say a pen in INDIA is worth 10 Rs and the same in USA is 2.5$, and the Foreign Exchange Rate is 5 RS/$. Then if the assumption of free trade prevails some one will purchase a Pen in INDIA for 10 Rs and then will go to USA and sell the same for 2.5$ and will convert the money at exchange rate of 5Rs/$ ie. 2.5 * 5 or 12.5 Rs and earn a profit of Rs 2.5 as he invested only 10 Rs on the pen. This if continues for a many cycles, will lead to high demands of pens in INDIA and the price of pens will go up because of such high demand and constrains in supply elements in short runs. In USA the supply will increase more than demand and price will fall. It will settle at a point until people find that the trade is now not productive. Now what will be the effects on the rates of exchange because this entire cycle. Just imagine, a lot of person are selling pens in USA so if free trade prevails then more and more dollars are sold for rupee increasing the imports of USA and Exports of INDIA. Than means INDIA is receiving more DOLLARS and this means the supply of DOLLARS will increase in INDIA. As they will not be constraint in supplies then the price of DOLLARS will fall eventually. Another thing to consider is that there are banks in INDIA and USA. These banks offer interest on the deposit's of money. As from the assumptions above made the prices in INDIA are higher than in USA, then the interest rates will also be high in INDIA as to compensate the time value of money. For example say the rate of deposit in USA is 5% pa and in INDIA it is 9%. Then assuming there is free trade in the economy there will be movement of spare funds from country with low interest rates to higher interest rates. This will increase the supply of dollar in INDIA then the price of dollar will get reduced as more and more funds will move to INDIA. On the other hand with this much investments in INDIA economic dev elopement will be speedy and in long run will result in lowering of inflation and then purchase price parity will kick in. This force is called the INTEREST RATE PARITY. Thus this proves the fact that INTEREST RATES are also factor influencing demand. The next issue is the most complex one. It is the Demand and Supply of foreign exchange. In relatively short terms one cannot change inflations and interest rates. The only factors that changes the rates are the demand and supply of currencies. One might say that it is sternly monitored by the government and there is no law or pattern to use in forecasting and planning. This is not absolutely true. There are two factors that needs considerations here, the first being that there is a huge amount of international trade that is conducted in one day and this influences the rates and secondly that governments and announcements too influences the rates. The action of the governments are mostly protective. No one tries to hinder trade of the country. So these actions are dependent on the surroundings. The trade activities are practically random and independent of one another. One may ask how to come to such a conclusion? Answer is very simple, say there is only a car wash center. Then the question that how many cars will come to the center and how many of them will stand in a cue is same as how many people will purchase exchange in one day. It is perfectly random and is independent events in short run. So one can estimate it as a probability model using the POISSON DISTRIBUTION. This distribution is nothing much more than the binomial distribution assuming that number of events approaches infinity and then taking the limit there. This distributions has been successfully used in may application where the events are generally random and are independent examples

being the number of mutations in the DNA and The number of soldiers killed by horse-kicks each year in each corps in the Prussian cavalry. This example was made famous by a book of Ladislaus Josephovich Bortkiewicz. Now let us go a little deep in the poission distribution. The notation of the poission is as below. Please try and interpret the informations in the equation rather than being bedazzled by the fancy terms.

where e is the base of the natural logarithm (e = 2.71828...) k! is the factorial of k. The positive real number is equal to the expected value of X and also to its variance. For example say What is the probability that 6 cars cross a particular signal in 10 minutes. If one knows the measure of central tendency of a distribution ie Mean, Median, Mode then it will for the expected value or (Lambda). Say the following is the past 6 experience we have in past 1 hour. 4 Cars, 7 Cars, 2Cars, 14 Cars, 3 Cars, 5Cars. Now as the disparity in data is very hight i would suggest the arithmetical means should not be used here. Now what will the value that true represents the situation, it is the geometric mean rather than arithmetical mean. Here the average will be 4.76 Cars. And placing the value based on equation above, we get the probability of this event happening that is .138 and if one needs to measure what is the probability of the number of cars should be less than equal to 6 we can find the cumulative function that is the area to the left of the point 6 or .796. Here i have used a simple geometric mean as an indicators of Lambda, but the other method that makes things more appropriate is to find the mean by the following equation :

Or one may say it simply as sum of events multiplied by the probability of their happening. It is the rate of success. So in the experiment above if we say that there is no apparent frequency and all have equal chances of happening . So as we known probability is number of occurrence's in a set of events divided by all likely possible events. Here there are 6 equally likely possibilities and so there is 1/6th probability of each event happening. So the expected value or the mean of this distribution is as follow; 4 Cars*1/6 +7Cars*1/6 +2Cars*1/6 +14Cars*1/6 +3Cars*1/6 +5Cars*1/6 Or 5.83 Cars One may say that it is nothing but the arithmetical mean, but that not absolutely true here. In this example it looks such. We don not want to achieve the arithmetical mean here. Say for example if we divide this in intervals. Say in the distribution above we say that what is the probability that less than 8 cars pass through. In that event the probability changes as it happens for 5 times in 6 events, so the probability becomes 5/6th and there is 1/6th possibility of that non happening. This changes the entire calculation. The chance of this happening is to be computed as summation of poission probability from 0 to 8 cars. So one would ask why we need so much information! The answer lies in thinking currencies as commodity. The price is derived by demand and supply of the commodity. If one can get a appropriation of the demand and supply he can make out the movement of price. Theses events are more or less random and are independent of one another. So this distribution seems appropriate. But the basic question is still intact, how come a common trader be sure that he is safe with so many fancy notations and operations involved. The answer lies in the coming section.

Deriving a Foreign Exchange Portfolio : Now think of an egg basket. The risk involved is that if one egg is spoiled the whole basket will be lost. So what is prudent to do is to place the eggs in different baskets. This minimizes the exposure. The confidence this initiate is that all the baskets will not get spoiled at once, the probability of this happening is highly unlikely. So what are we suggesting is that we place some assets with the exchanges to make our exposure small. The most important question is HOW. The answer to this question is very simple. Now assume a country such as INDIA. It is a developing country and the big corporate houses actively indulges in foreign trade. If in the country the value of Rupee depreciates then this hampers the trade activity as doing business becomes expensive. As a result the market stock Index falls. As the confidence in the stock market is hampered by the reduction in trade activities. Now the cause of excitement is that we can prove this, we will take the DOLLAR TO RUPEES value for the past 1 year and the market index to show the relational movements. Say for first reference we take data from December 1st to December 19th :
DATES 2/12/2013 3/12/2013 4/12/2013 5/12/2013 6/12/2013 9/12/2013 10/12/2013 11/12/2013 12/12/2013 13/12/2013 16/12/2013 17/12/2013 18/12/2013 19/12/2013 VALUE OF 1 US$ IN INR 62.2987 62.3318 62.0325 61.7657 61.3432 60.9532 60.977 61.2603 61.7841 62.085 61.8296 61.8495 61.9362 62.1794

DATE 2/12/2013 3/12/2013 4/12/2013 5/12/2013 6/12/2013 9/12/2013 10/12/2013 11/12/2013 12/12/2013 13/12/13 16/12/13

BOMBAY STOCK EXCHANGE INDEX 20898.01 20854.92 20708.71 20957.81 20996.53 21326.42 21255.26 21171.41 20925.61 20715.58 20659.52

17/12/13 18/12/13 19/12/13

20612.14 20859.86 20708.62

Graphing above simulation we can see the co movement of both foreign exchanges and index -

Here the blue defines the Dollar Value and the red defines the INDEX. If one tries to measure the correlation it will come to -.8061 that is very nearly perfectly negatively correlated. Now we take another example.
DATES 1/10/2013 3/10/2013 4/10/2013 7/10/2013 8/10/2013 9/10/2013 10/10/2013 11/10/2013 14/10/2013 15/10/2013 17/10/2013 VALUE OF 1 US$ IN INR 62.4491 62.0006 61.5228 61.6273 61.778 61.8183 61.4924 61.136 61.3477 61.6318 61.1796 BOMBAY STOCK EXCHANGE INDEX 19517.15 19902.07 19915.95 19895.1 19983.61 20249.26 20272.91 20528.59 20607.54 20547.62 20415.51

18/10/2013 21/10/2013 22/10/2013 23/10/2013 24/10/2013 25/10/2013 28/10/2013 29/10/2013 30/10/2013 31/10/2013

61.2136 61.3102 61.4197 61.5068 61.4057 61.4801 61.4999 61.3841 61.3076 61.5365

20882.89 20893.89 20864.97 20767.88 20725.43 20683.52 20570.28 20929.01 21033.97 21164.52

THE GRAPHICAL REPRESENTATION SHOWS :

The correlation is coming to -.71425 that is very good for a period of 1 month. Then how important is this movement. Say if we have to purchase some foreign exchange and we have to hold it for some time. Then we can hedge ourself with many Money Market Hedge instrument. But this still requires skills and operations that all will not understand. Then what is the easy way out? The way is simple make this portfolio. Take markets as the second commodity and exchanges as the first. So in october chart above what is the risk of a person. When we try and find the risk of a particular assets we take the standard deviation. The standard deviation is the absolute deviation of data points from the mean. They measure the dispersion from central tendency. This brings uncertainty to it and thus makes it risky. Here the standard deviation is .2995 for foreign exchange and 443.81 in stock market. The geometric mean of the foreign exchanges is 61.5253 in exchanges and 20488.3225 in index. So the deviation to mean percentage is .487% and 2.1661% in

exchanges and index respectively. That means the dispersion in stock is manifested longer and is a direct result of foreign exchanges fluctuations as they go through many different operations and this magnifies the dispersion of .487% to 2.1661%. Now the risk of the portfolio is given by THE GREAT MARKOVITCH PRINCIPLE OF PORTFOLIO :

( X 1* X 2 * 1* 2 * R1,2)
That simply means X1 and X2 are weights of both security in the portfolio. Sigma represents the standard deviations both securities and R1,2 are correlations between different commodities. Double summation means to make analysis in all permutations possible. Here first is Security 1 with itself and then Security 2 with itself, lastly Security1 with Security 2 and Security 2 with Security 1. So the risk here becomes, assuming equal representation of both in portfolio : Standard Deviation of Portfolio = 221.7964, if one find the return of the return of this portfolio he will see that the dispersion is very less as compared to individual securities above because of the negative correlations of both the exchange and index. Now there may still be persons who say that we further want to protect our investment in Index. So we can use the CAPITAL ASSET PRICING MODEL along with some basic SET THEORY. Fist we need the BETA of the exchange market. BETA is the measure of Std Deviation of a assets weighted by the CORRELATION between market and security per unit of deviation in the Stock Index Market.

ri, m *i /(m) It becomes .-714265 * .2995 / 443.807 = -.0482% that means that in return of increase in exchange rate market drops.
Now to strengthen the Index side infusion of risk free assets in the portfolio assuming only the Index side of our primary portfolio will further improve our solution. Thus what we suggest here is to make something like a sharing set with common objects. Here we make two portfolio with only three assets. It makes kind of a Venn diagram. The common object is the INDEX.

The same principle in enshrined in the capital assets pricing model that can help us determine the right combination for the portfolio and the risk calculation will be same as the principle above. Please do see the diagram below for better understandings.

FIGURE SHOWING THE INTERSECTING SETS OF EXCHANGE AND STOCKS WITH RISK FREE ASSETS. REGARDS AKASH KAPOOR BLAW, CA (ATC), CME(UK), CPFP(IRVINE), DIP(LEGAL) Email Id : Kapoor.akash12@rediffmail.com ; Kapoor.chiku@gmail.com

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