Multi-currency collateral management has become an integral part of overall risk management. This is particularly true as regulations push to collateralize the funding of derivatives, and require more derivatives to be central cleared. The increase in collateralization is making multi-currency derivatives strategies more complex.
In order to gain a comprehensive view of risk, institutions need to accurately incorporate the FX exposure from their multi-currency collateral management. The problem is that some firms are ignoring the FX basis risk inherent in the underlying collateral agreements for multi-currency derivatives strategies.
So what is the best way to remedy this issue? More firms are electing to integrate FX collateral management into their derivative valuation and risk framework. This approach is helping them achieve more accurate and comprehensive risk reports, better hedging and improved returns.
There are four important considerations that you should incorporate into your pricing and risk models in order to get an accurate, holistic view of risk across the enterprise. These can be derived by answering the following questions:
- What is my investor profile? The investor profile consists of how you are funding a trade, and in what currency you issue bonds or raise cash. For example, there can be a significant pricing difference for the same trade depending if you are a USD investor, GBP investor or another type of investor.
- What is my cash flow hedging strategy? A cash flow hedge is used when an entity is looking to eliminate or reduce the exposure that arises from changes in the cash flows of a financial asset or liability (or other eligible exposure) due to changes in a particular risk, such as interest rate risk on a floating rate debt instrument. Your cash flow hedging strategy should include what trade you would enter into in order to reduce market risk.
- In what currency do I have to deliver collateral? Here you should consider what your CSA says, and what your central counterparty requires of you. This is important because for a given trade you may be exposed to different areas when delivering collateral in a foreign currency.
- What is my foreign collateral management strategy? Take note of how you deliver collateral in foreign currencies. This consideration is crucial to helping you understand where additional exposures may lie.
As a trader, you will see significantly different risk profiles depending on your particular hedging and collateral management strategy. If you take a siloed approach to risk reporting, without any controls over a consistent market model, then most likely you will see significant inaccuracies when you aggregate exposures across the enterprise.
However, with a holistic, consistent, arbitrage- free view on risk, you will gain a more accurate window into your market risk. You will also be empowered to take a more strategic approach when devising the most cost-effective hedging and collateral management strategies possible.
For more information and detailed examples on this topic, please download our brand new eBook: Uncovering Derivatives Hidden Risk: Best Practices for Multi-Currency Portfolios.