Foreign Exchange Risk in Albania

Abstract

Foreign exchange risk is the potential for loss due to an adverse change in foreign exchange rates, and applies to all exchange rate–related products whose positions are valued in a currency that differs from the bank’s reporting currency. Eventual movements in the exchange rate are a risk for investors and businesses with international operations. Therefore, they adopt strategies to minimize the impact of eventual adverse movements. This is known as hedging, and it involves using financial instruments to increase protection against currency fluctuations. Hedging makes transactions, cash flows and cost structures more stable and predictable. There are different strategies which are designed to manage foreign exchange risk. Each of them, however, is constructed under specific assumptions, for a specific risk profile. The question arises as to which strategy would be expected to yield the best results in a given scenario. The first part of the current study describes how do banks measure and hedge the foreign exchange risk by using a set of simulated foreign exchange cash flows to compare the profits resulting from the use of different foreign exchange risk management strategies. The key risk metrics to measure the foreign exchange risk considered for this study are: Value at Risk and Stress Testing. The risk management strategies considered to hedge foreign exchange risk for the study are: forward currency contracts, currency options, and currency swaps. The study analyses and evaluates these foreign exchange risk management strategies to find out which of the strategies is appropriate in particular situations for banks and for non-financial corporates. The second part gives some statistics about open foreign currency position and the risk appetite in the Albanian banking market and how non-financial firms could use financial derivatives to hedge the foreign exchange risk.