Measuring and Managing Foreign Exchange Risk at a Large Pharmaceutical Firm: Application of Value at Risk

Abstract

The present study has been carried out on the express request of a major pharmaceutical firm. The firm has substantial foreign exchange exposure and it needs a tool which can be used for managing foreign exchange risk. In this paper as the calculation of Value at Risk (VaR) is to deal with the risk involved with the options, their non-linear payoff nature, it is more challenging to incorporate all the option sensitivities in the model that we adopt to measure VaR. As the portfolio consists of currency pairs, it was more important to preserve correlation of the currency pairs while measuring VaR using any approach. We calculated delta of each option of the portfolio by using Black-Scholes option pricing formula and thereby calculated the unhedged amount for each asset in the portfolio. We have used variance-covariance approach, historical simulation and Monte Carlo simulation to calculate VaR. After comparison of results by weighing their advantages and disadvantages, historical simulation was ruled out to implement as it will not consider correlation between the assets. We have chosen to implement Variance-Covariance approach against the Monte Carlo simulation method mainly because it takes correlation into consideration and the latter is less transparent. Variance-Covariance approach is also faster and relatively easy to implement when compared to the Monte Carlo simulation. We designed a template using Excel VBA and MATLAB to calculate weekly VaR with the input variables (Current price of the underlying, Strike rate, Time to maturity, Volatility, Risk free interest rates of the currency pairs) and from the result we can interpret whether we are over hedged or under hedged using options as our hedging strategy. This study provides the insight of what can be the value still at risk when the firm is hundred percent hedged using options because of the option sensitivities. It also provides a lucid interpretation to the risk management executive to understand his position on the option hedging strategies.