Series on Issues in Corporate Risk Management - Part 2 - Stick to Objectives
Series on Chart Patterns - Careful with the Shoulder Head Shoulder
ISSUES IN CORPORATE RISK MANAGEMENT
Keep the Objective in mind. It pays
The definition of proper Objectives is the first step in effective Corporate FX Risk Management. Get your objectives wrong and you are most likely courting trouble. We had taken this up in the Issue dated 28-Mar-04. Having set the correct objectives, the Risk Manager needs to keep them in mind after the Hedge Strategy has been implemented, so as to not be led astray by the market. It pays immensely.
A conglomerate with a Rupee Balance Sheet had a large foreign currency loan book, 85% of which was denominated in US Dollars. The balance was in D-Marks, Yen and Sterling. Circa 1994-95, the Risk Manager decided to reduce the currency concentration risk and rebalance the loan basket using Currency Swaps. The Objective was clearly defined as Risk Diversification.
It was decided to swap 10% of the Dollar loans into Yen. The Yen was chosen because interest rates were close to zero as compared to 6.50-6.75% on the USD 6-month Libor, giving a huge interest benefit. Further, the Yen was expected to weaken over a 3 year time frame. The Swap took place in Jan-95 near 100 on the USDJPY Spot.
Almost immediately thereafter, the Dollar dived against the Yen, to hit an all time low of 79.80 in April 1995. There were 3 months of intense agony. The company had never undertaken such a large forex deal. The Board was on the edge. Had the deal gone horribly wrong? The Risk Manager reminded the Board that the objective was Risk Diversification and only 10% of the loan book had been put on the line. Further, the deal had a 3 year tenor.
The market eventually turned around and the danger passed. The Swap came back into money. Now the Board was tempted to square off the trade and book whatever small profit was available. Again the Risk Manager stuck to his guns, saying the Objective was long term Currency Diversification, not short term Trading Profits. The Board backed down and the Swap was allowed to run its course.
The Yen eventually touched 120 in 1997. The company booked a huge currency and interest rate gain of almost $17 million. Those who have been in the market through that period would appreciate how difficult it must have been to steer such a trade through to its end. It is immensely commendable that the Risk Manager did not waver from the Objective, neither in bad times nor in good times.
The gains from the deal (which in itself was well conceptualized), was realized by remaining focused on the Objective.
SERIES ON CHART PATTERNS
The Shoulder Head Shoulder
A common mistake
The Shoulder-Head-Shoulder is one of the most popular Reversal patterns in classical charting as it is visually appealing and promises handsome gains if read correctly. Sometimes, Chartists tend to make a common mistake in reading it though, as illustrated below:
The fault lay not in the chart pattern, but in the initial reading. A very important point to remember about SHS is that the profit objective from the Neckline is roughly equal to the distance between the Head and the Neckline. As such the previous trend should have been of a sufficiently long duration to accommodate the profit objective. Further, since the SHS is a Trend Reversal pattern (not a Trend Correction pattern), there should ideally be further room available (beyond the profit objective) for the new trend to perpetuate. These conditions were not met in this case of a "false" SHS.
The Charts aren't perfect, though
Of course, It does happen sometimes, that even a Classical SHS, meeting the conditions mentioned, does not deliver to its full potential, as seen alongside. The GBPUSD had developed a pronounced Bear SHS in Q1-04, with an ideal Profit Objective near 1.7150. Unfortunately, the low seen was only 1.7480 on 14-May-04, well short of the target.
Since Charting is not an exact science, the only way to deal with this would have been to employ a Trailing Stop Loss to protect Short positions. This is the realm of skilful Trading, an ability acquired with effort and experience.
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Chart Patterns, again
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