Currency risk in foreign currency accounts for small and medium-sized businesses

Lorenzo Reus

Abstract

This paper estimates the currency exposure before and after the hedging of active foreign currency (FC) accounts, using stochastic models for spot exchange rates and cashflow movements. It examines a simple hedging policy that is typically applied by small and medium-sized businesses that do not have the expertise or resources to execute sophisticated strategies. The performance of the policy is measured through the derivation of analytical expressions for its profit and loss (P&L): that is, the earnings resulting from the valuation of the FC accounts and of the forward contracts taken. The results for five currencies show that the policy reduces P&L volatility compared with that for an unhedged account, without necessarily reducing the mean P&L. The mean and volatility of the P&L are not sensitive to the maturity of the contracts, and the volatility is almost linearly related to the currency volatility.