Foreign Exchange Risk Management at Microsoft
Introduction
Risk is omnipresent and corporate world is no exception. Companies face a wide range of risks. This article allows the readers to get access to the entire risk management mechanism at the Microsoft. The article also presents a conceptual note on VaR (Value at Risk), a risk measurement mechanism used by Microsoft. The article also deals with the customized mechanism designed by Microsoft using options and forwards contracts to reduce its foreign exchange risk.
Company Profile
William H Gates and Paul G Allen founded Microsoft as Partnership Company on April 4, 1975. Microsoft was incorporated on June 25, 1981. Headquartered in Redmond, Washington, Microsoft operates in more than 60 countries with manpower of 44,000. Microsoft’s geographical operations can be divided into five regions Europe and Middle East, Americas, Asia, Africa and Pacific, where it has got offices. However, Microsoft’s products are marketed across the globe.
Foreign Exchange Risk Management
Since 1997, under the leadership of Maffei, Microsoft adopted a systematic approach to manage foreign exchange risk. The company started matching the time horizons of hedges with the time horizons of the exposures. The company uses sophisticated techniques like Monte Carlo simulations to determine the probability distributions of future exchange rate fluctuations. Based on these probability distributions, the risk management team compares the effectiveness of their hedges against the costs involved in these transactions. The primary currencies that the company deals with include Euro, Japanese Yen, British Pound and Canadian Dollar.
The use of VaR
Microsoft applies VaR3 (Value-at-risk) to manage its market risks that include foreign currency, fixed income, interest rate and equity price risks. The company uses VaR as risk estimation and management tool rather than to represent actual losses in fair value. As far as the currency risks are concerned, the company uses geometric Brownian motion. The model enables it to incorporate the optionality with regard to the risk exposures.
Value-at-risk is calculated by, first, simulating 10,000 market price paths over 20 days for equities, interest rates and foreign exchange rates, taking into account historical correlations among the different rates and prices. Each resulting unique set of equity prices, interest rates, and foreign exchange rates are applied substantially to all individual holdings to re-price each holding. The 250th worst performance (out of 10,000) represents the value-at-risk over 20 days at the 97.5th percentile confidence level. Several risk factors are not captured in the model, including liquidity risk, operational risk, credit risk, and legal risk.
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