Foreign Exchange Risk margin
The source material provides two ways of calculating Foreign Exchange risk margin:
1. 10% * MAX(net long position, net short position)
2. 10% * MAX(net spot rate - carve-out, 0)
How do we know which one to use when?
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The source material provides two ways of calculating Foreign Exchange risk margin:
1. 10% * MAX(net long position, net short position)
2. 10% * MAX(net spot rate - carve-out, 0)
How do we know which one to use when?
Comments
The second formula above is from section 5.2.2 which is excluded from the syllabus so just use the first formula.
Hola! Just want to confirm... if there is a single currency, the first formula is equivalent to 10% * abs(assets-liabilities)?
But when there is more than one currency, then need to compare the sum of net long position vs sum of net short position and take the max?
Hola @victoriadiaz!
There is no example in the text from section 5.2.1 but an exam question should tell you the net long position or net short position. You would then do the 10% calculation separately for each currency and sum the result. The section of the MCT reading that's on the syllabus for foreign exchange risk is very short and any problem you get on that topic shouldn't be any more complicated than the foreign exchange risk part of this exam problem from 2018:
For reference, here is some background on net spot positions, including long and short positions:
A net spot position, a net long position, and a net short position refer to an investor's exposure to changes in foreign currency exchange rates. These terms are commonly used in foreign currency trading and investment.
Net Spot Position: A net spot position is an investor's overall exposure to a particular currency at the current exchange rate, or "spot rate." If an investor holds a net positive balance in a particular currency, they have a net long spot position; if they hold a negative balance, they have a net short spot position.
Net Long Position: A net long position in a foreign currency means that the investor owns more of that currency than they have sold. In this situation, the investor will benefit if the exchange rate for that currency increases, as their holding will be worth more in their base currency.
Net Short Position: A net short position in a foreign currency means that the investor has sold more of that currency than they own. In this situation, the investor will benefit if the exchange rate for that currency decreases, as the value of their holding will decrease in the base currency.
Got it! I might be overthinking this but just to conclude, the "max(net long, net short)" is only relevant if there is those two types of positions for different currencies?
Gracias
I want to say yes to your question but this is a case where I really wish the source text had a better example to illustrate how the calculation is done.
Having said that, most of the material on foreign exchange risk was removed from the syllabus so I have to think that the CAS doesn't consider that calculation to be important. Any exam question on that topic should therefore be very straightforward just like in the exam problem I referenced above. I know that's not a completely definitive answer but that's all I can really say based solely on the text.
No worries! I just wanted to make sure I wasn't missing something. But good news that it should be that simple. Thank you very much
Hi @graham , as a follow up to your above posts.
Is the following statement correct?
1. Net long Position= - Net Short Position
2. We take the max of long and short such that Margin(FX) >0
In the fall 2018, we only had net long position for both US dollar and euro.
So we technically multiplied each of them and add them together.
If instead we were given a net long position for US=100 and net Short position for Euro= - 200(negative 200)
Is the margin(FX)= 0.1*(100+200) since Net **Long ** Position for Euro= + 200
Based on my reading of the text, your calculation for the margin(FX) is correct.
But I'm not sure about your Statement 1 above. I understand your thought process but technically, if there is a net long position, then there is no net short position, so it doesn't really make sense to say the long position is the negative of the short position.
The whole idea behind the margin for foreign exchange risk is that the more foreign currency is in your portfolio (whether it's long or short) the more risk you have. So you just take the absolute value of all your holdings, add them together, then multiply by 10%. It's a very rough measure and likely not to be a big part of an insurer's holdings. Otherwise the MCT calculation might need to be more sophisticated to get a more appropriate value for the foreign exchange risk margin in various circumstances.