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Using Monte Carlo Simulation to Hedge Against Volatile Exchange Rates

Nov 1, 2022

The US dollar is at its highest level since 2000, up more than 20 percent over other major currencies such as the British pound, the euro, and the yen. The current economic forecast is for more volatility in 2023, which tends to drive further demand for the dollar, seen as a safe harbor investment during periods of uncertainty.  However, as we’ve seen with the rapid depreciation of major currencies this year, this could change at any moment.  It’s important to account for variability and uncertainty as part of the treasury planning process heading into next year.

The strong dollar means potentially significant losses for US firms who transact in foreign currencies.  When those sums are eventually converted back to dollars, their value will be substantially reduced.  Short of simply transacting exclusively in US dollars – an unrealistic prospect for most international firms – the most common tactic for mitigating such foreign currency risk is to hedge against future movements in the value of the currency.  This can take the form of options, which give the holder the right (but not the obligation) to buy or sell an asset such as a currency at a specifed price, or of forward contracts, which obligate the holder to buy or sell an asset at a given price.

In order to determine the best hedging strategy, a sophisticated understanding of likely future movements of currency prices is needed.  Monte Carlo simulation fits this bill very well, providing a view into hundreds or thousands of possible future outcomes, with or without a hedging strategy in place.  Furthermore, simulation of time-series variables – or factors that move over time, such as exchange rates – is critical. In addition, Monte Carlo can be performed on multiple hedging strategies, enabling decision-makers to identify the optimal strategy to meet their goals within their specific risk tolerances.

The model linked below provides a simple example of how a hedging strategy – the purchase of put options, which give the holder the right to sell a currency at a given price – can significantly improve the likelihood of better outcomes in today’s foreign exchange environment.  The model uses @RISK Industrial to run the analysis, which includes advanced functions for modeling time-series variables.

Download the Example Model: Exchange Rate Hedging
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