GLOBAL ASSOCIATION OF RISK PROFESSIONALS

The GARP Risk Series

MARKET RISK MANAGEMENT

Chapter 2 | Foreign Exchange Markets, Instruments and Risks

Currency Regimes Determine to what extent a countrys government manages its currency relative to other currencies Free float
A currencys value varies freely Market determines the value Managed float
Active intervention in the markets to maintain the exchange rate within an acceptable range

Fixed exchange rate

A currency's value is fixed to the value of another currency or a basket of other currencies The value of the currency is pegged to another currency
The HKD is fixed against the USD Exchange rates move in a band between 7.757.85 USD/HKD

Exchange rate data and volatility calculated by Bloomberg.

Primary Source of Foreign Exchange Rate Risk Pure currency float

Market determines rates
The value of the currency appreciates or depreciates freely
Interest rates, economic conditions, expectations

Typically smaller but regular changes

Fixed currency system

Change in currency regime
A previously fixed currency becomes floating The rate is adjusted

Typically substantial but infrequent changes Political risk

Example of Foreign Exchange Rate RIsk Foreign exchange risk

The potential loss due to currency exchange rate fluctuations
Monthly exchange rate
Exchange rate Swedish krona / U.S. dollar
11.00 10.00 9.00 8.00 7.00 6.00 5.00 4.00 3.00 Jan 72 Jan 77 Jan 82 Jan 87 Jan 92 Jan 97 Jan 02 Jan 07

Swedish Kronor to One U.S. Dollar, Noon buying rates in New York City for cable transfers payable in foreign currencies. Monthly average rate from Board of Governors of the Federal Reserve System; available through St. Louis FRED database.

From Fixed to Floating Interest Rate Regimes Foreign exchange risk

The potential loss due to currency exchange rate fluctuations
Monthly exchange rate
8.0

7.5

Exchange rate Swedish krona / European Currency Unit (ECU)

7.0

6.5

6.0

5.5

5.0 December 1978 December 1981 December 1984 December 1987 December 1990

Swedish Kronor to One European Currency Unit. Daily fixing rate at 9.30 a.m; from the Riksbank. Devaluation information from the Riksbank.