Managing Risk In Forward Euro Exposure
Abstract
The measurement of risk of the portfolios has a very important role in risk management. We use the PCA factor model to decompose the risk from a sequence of forward foreign currency payments into interest rate, exchange rate and correlation components. In this paper we focus on the application of PCA to forward currency exposures and futures positions in commodity. The contract will be related to British importer purchasing grain or another commodity in euro. The euro price of grain has been fixed and there is no commodity price risk. In this paper we show how to decompose the total risk into three components, namely into the exchange rate risk that arises from uncertainty about the British pound value of future payments in euro, the interest rate risk that arises from the change in present value of the British pound cash flows and the correlation risk that arises from British exchange rates and the euro-dollar exchange rates and how to isolate the key interest rate risk factors.
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