Currencies are prices. Prices determined by the international financial markets as is the case for other securities: shares, bonds, etc. As with any other financial decisions, before buying or selling, you have to assess the right relationship between risks and benefits. While determining whether to take risks or not, both the positive and the negative side effects must be taken into account.
Benefits and any side effects should be evaluated with respect to two factors: the magnitude and the probability of occurrence.
Obviously, the benefits are “desirable;” a given investment is made to obtain a particular financial result, which could lead to a yield or to avoid a financial loss so that the resulted balance is positive and the unwanted effects must always be “less” and “less severe” than the benefits.
BENEFITS AND RISKS OF A BANK ACCOUNT
An example. A side effect of keeping cash deposited in the bank account is the lack of yield. The bank does not grant the interest rates if we want to maintain the possibility of withdrawing at any time.
But if we need liquidity (i.e. for sudden emergencies), then we should keep cash in our current account, being aware that you do not get financial returns. In this case, the probability that the amount of cash being used for emergencies is considered high, while the probability of having side effects is lower and is still a better alternative to remaining illiquid when unforeseen events occur. So, in the end, a liquidity reserve protects from bad surprises.
Holding liquidity, however, is not 100% risk- free. Recently, the new European banking legislation introduced the possibility of losses for banking accounts over € 100.000 in case of bankruptcy; the so-called “bail-in.” It is a rare risk (with a low probability), but having no money, when it is needed, is a too big risk (a major impact). Risks and benefits are not the same, so in this case, it is preferable to limit the amounts of risk by sharing cash among several banks.
Attention: it is not correct to say that banks are at risk. Instead, the cash amounts exceeding €100.000 are at risk. It is very different. We can apply the same criterion of choice to every financial decision. We can estimate how great the risks are and what the chances are that they will occur.
BENEFITS AND RISKS OF FOREIGN EXCHANGE
In the case of currencies, we can estimate the most likely scenario with specific quantitative calculations. Let’s see how with a concrete example of the future payments to a supplier in US Dollars.
Companies that have foreign providers to be paid in US Dollars have to deal with a fragile situation. At the beginning of the year, the Euro/Dollar exchange rate was 1,05, and now the Euro recovered to over 1,14. Since we are currently experiencing the relative strength of the Euro, a careful evaluation of the scheduled foreign payments should be done.
One real case is that of a company that has payments to be done to foreign suppliers in US Dollars. The invoices scheduled until the end of the year amount to a total of €300.000, equivalent at current Euro/Dollar exchange rates.
The equivalent amount in Euro that the company will have to pay upon the expiration of each invoice depends on the future Euro/ USD exchange rate at the date of payment. At today’s exchange rate, the total amount for the three bills is €300.000, but if the Euro depreciates against the US Dollar, the bill would be more expensive.
First question: How expensive is it? How much would this company have to pay? According to the Ekuota risk calculator, the company is likely to pay a total of €333.214. That is €34.000 more than today’s values (see table below).
Table – Calculating the risk related to the purchases of US Dollars for payment to foreign suppliers
Second question: What is the probability that this will happen? Is it a concrete risk or not? In the Figure below, we can see the graphic analysis of the scenario forecasted at the year’s end.
There is a 70% probability (calculated with Ekuota’s probabilistic statistical model) that the risk will occur. Then, the unfavorable scenario of a depreciation of the Euro against the US Dollar has a very high probability. It is a risk that needs to be monitored carefully.
Now that we can evaluate the benefits and the risks of the decision on future purchases of US Dollars to pay foreign suppliers, we have all the elements we need; we know both the magnitude of the risk and the probability.
We know that the magnitude of the loss is measured accurately and has an amount known (a payment of €34.000 more than today’s price). We also know the likelihood that the US Dollar will be more expensive than today, with a probability of 70%.
With this key information being available, we can make our financial decision. If we consider it is too high a risk for our company and we want to defend the liquidity and the margins of the income statement, then there are two possible alternatives:
- Keep US Dollars in a bank account, available for the scheduled payments;
- Hedging transactions: a forward contract for purchasing US Dollars at the expiration date of the invoices. This will allow you to fix the amount in Euro to be paid to the supplier.
Today, companies and their managers have access to highly effective technologies that enable them to obtain all the information they need in order to set up their financial strategy. Such technologies have been adopted by international financial institutions because they lead to measurable results. Taking advantage of all the best information available is an opportunity that allows companies to get better results than their competitors.
Through probabilistic financial technology (available through Ekuota), companies now have a competitive advantage and know when it is the right time as well as if these are the best market conditions. A unique opportunity to avoid possible financial losses.