Currency Risk Management and Diversification
Every business owner is exposed to some type of risk in their everyday life – whether it’s from driving, walking down the street, selecting stock lines or something else. A business owner’s personality, lifestyle, age and business experience are among the key factors to consider for individual risk purposes. Consequently, each business owner has a unique risk profile that determines their willingness and ability to withstand currency fluctuations. In general, as perceived financial risks rise, greater returns are expected to compensate for taking those risks.
Quantifiably, risk is usually assessed by considering historical price behaviour and outcomes. In the finance world, standard deviation is a common metric associated with risk Standard Deviation provides a measure of the volatility of a value in comparison to its historical average. A high standard deviation indicates a lot of value volatility and therefore a high degree of risk.
Business owners typically develop risk management strategies to help manage risks associated with their business activities. Measuring and quantifying risk often allows business owners to hedge some risks away by using various strategies including diversification and derivative positions.
Perhaps the most basic (and effective) strategy for minimizing risk is through diversification. Diversification is based heavily on the concepts of correlation and risk. A well-diversified currency portfolio will consist of different hedging structures that have varying degrees of risk and correlation with each other’s returns.
While most investment professionals agree that diversification can’t guarantee against losses, it is the most important component to helping business owners reach long-range financial goals, while minimizing the risk of potential losses.
There are several ways to plan for and ensure adequate diversification including:
- Spread your currency portfolio among many different hedging structures. Look for a mix of transactions whose returns haven’t historically moved in the same direction and to the same degree. That way, if part of your currency portfolio is declining in value, the rest may still be increasing;
- Stay diversified within each type of hedging structure. Include a variety of maturity dates and time horizons;
- Include structures that vary in risk. You’re not restricted to picking only those structures that provide absolute certainty. In fact, the opposite is true. Picking different hedging structures with different rates of return will ensure that large gains can offset losses;
- Consider a variety of transaction providers. When one provider does not have a risk appetite for your business or industry another may.
Keep in mind that currency diversification is not a “set and forget” concept. As business owners perform regular reviews to ensure that their business is operating at an optimal level, so too can this approach be applied to the review of financial risks within the business. This will necessarily result in a review of the current currency portfolio and may result in the need for it to be rebalanced to ensure that the risk level is consistent with the redefined overall business strategy and goals.
The Bottom Line
We all face risks every day. In the financial world, risk refers to the chance that a financial transaction’s actual return will differ from what is expected – the possibility that it won’t do as well as you’d like, or that you’ll end up losing money.
The most effective way to manage financial risks is through regular risk assessment and diversification. Although diversification won’t ensure gains or guarantee against losses, it does provide the potential to improve returns based on your goals and target level of risk. Finding the right balance between risk and return will help business owners achieve their financial goals through decisions that they can be most comfortable with.