Global financial markets are flooded with information,
opinions and advice on the expected development of currency rates. Those
responsible for managing FX exposures suffer from the headache that nobody can
predict exchange rate movements dependably in the long-term. Consequently, FX
hedging decisions frequently remain based on guesswork. This comes at the cost
of forgone participation and unnecessary exposure to currency risk. What if
there is a way to deal with the uncertainty of FX markets systematically and
40% chance of rain
What do you do when there is a 40% chance of rain? Do
you bring an umbrella; or do you choose the risk of being surprised by rain?
Humans must identify and manage risks every day in
numerous situations. However, our brains face cognitive limitations affecting
our behaviour, especially under uncertainty. These constraints often lead to
overestimating low probability situations and underestimating real
In such situations, there are opportunities for
intelligent methods to assist in the decision-making process. Modern technology
can deal with millions of data points and their probabilistic distributions far
better and more consistent than humans can.
In the context of currency management, the key
questions are how much to
hedge and when?
HedgePilot - an AI-based FX-hedging tool
LPA developed a system called "HedgePilot"
to answer these challenges and support those tasked with managing foreign
currency. Our solution considers each trade situation and systematically deals
with FX market predictions to reduce unknown or unwanted currency risks. The
AI-based algorithm continues its learning with new data, constantly improving
HedgePilot is accessible via the web and can be used
in addition to existing treasury tools. It provides tradeable signals based on
the latest market data and consistent with any hedging policy and risk attitude
a user might have.
Users can participate in beneficial market movements,
while exposures are limited through a continuously monitored risk-limit
enforced with a stop-loss. Essentially, we offer the payout profile of an
FX-option without charging an expensive upfront premium.
AI is no longer a Black Box.
AI is often referred to as a "Black Box". However, due to recent
research and developments in applied algorithms, this statement is no longer
accurate. Given recent advances in AI, we can dissect the signals generated by
HedgePilot and provide insights into the algorithm's decision-making.
In contrast to a traditional economic model, with
fixed variables and relations between them, our technology adapts to changing
patterns and realities. Ultimately, traditional economic models are
simplifications of reality, lacking robustness when faced with inadequate data.
Subsequently, there has not been a single model that has successfully and
consistently predicted FX movements. Rather than restricting ourselves through
a pre-determined model with limited validity, we enable technology to search
and identify patterns. This set-up is a systematic way of learning from the
inherent uncertainties of market developments.
Determining the playing field
Based on LPA's decades of expertise, we determine the
playing field on which the algorithm is trained. We ensure that the input
parameters, such as hedge strategy and hedge policy, always lead to signals
that lie within plausible boundaries during the training process. Extreme market situations are simulated, assuring the
algorithm learns from unobserved realities. As a consequence, the algorithm
cannot veer onto unwanted paths, even during extreme situations.
Furthermore, rather than predicting an exact currency
rate, we forecast probabilities (i.e. 40% of rain) and weigh various outcomes
with possible client strategies. We embrace a systematic way of learning from
the inherent uncertainties of market developments.
Safety features, comparable to driver-aids in modern
automobiles, provide an additional layer of security:
- Continuous "live" monitoring of various
parameters to ensure HedgePilot performs as intended and tested.
- Automatic stop-losses to respect the risk
tolerance of each customer.
- Several features can be customised, such as the
minimum trading amount and lot size.
- Extensive and continuous quality assurance,
including rigorous backtesting of each currency pair.
Because of all of the steps undertaken in the
algorithm's development, and the fail-safes controlling the signals, we ensure
that we do not receive implausible behaviour.
This quality applies to each signal generated through
HedgePilot. Therefore, we believe that HedgePilot in the long-term will
consistently beat any human-based decision - a development already seen in
other industries, including chess and go.
Date: 25th of January
Written by: Julian Osborne