foreign exchange risk chapter 14 © 2008 the mcgraw-hill companies, inc., all rights reserved....
TRANSCRIPT
Foreign Exchange Foreign Exchange RiskRisk
Chapter 14
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.McGraw-Hill/Irwin
14-2
Overview
This chapter discusses foreign exchange risk to which FIs are exposed. This issue has become increasingly important for FIs due to hedging needs and speculative positions taken to increase income. With greater integration of global markets, this is an issue for almost all FIs.
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Background
Globalization of financial markets has increased foreign exposure of most FIs.
FI may have assets or liabilities denominated in foreign currency (in addition to direct positions in foreign currency).
Foreign currency holdings exceed direct portfolio investments.
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Foreign Exchange Rate Quotes
Price at which one currency can be exchanged for another Direct quote: In the US, this means the price of
the foreign currency expressed in US dollars. Example: US$0.8866 per Canadian dollar (C$).
Indirect quote: In the US, this means the price of the US dollar in terms of the foreign currency.
Example, C$1.1279 per US$. *Note that the terms direct and indirect,
depend on where the quote is obtained. Direct quotes in Canada would be expressed in
terms of C$ per unit of foreign currency.
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Sources of FX Risk
Spot positions denominated in foreign currency
Forward positions denominated in foreign currency
Net exposure = (FX assets - FX liab.) + (FX bought - FX sold)
Some decline in FX exposure as a result of the Asian, Russian and Argentinian crises
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FX Risk Exposure
FI may have positions in spot and forward markets. Could match foreign currency assets and
liabilities to hedge F/X risk Must also hedge against foreign interest rate risk (by
matching durations, for example) Financial holding companies have even greater
ability to reduce their net exposure.
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Trends in FX
Value of foreign positions has increased Volume of foreign currency trading has
decreased Causes:
Corporate and investment bank mergers Increased trading efficiency through
technological innovation Introduction of the euro Macroeconomic factors
But, average daily turnover has rebounded Search for yield
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For statistics related to FX trading, visit:
Bank for International Settlements www.bis.org
Web Resources
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FX Risk Exposure
Greater exposure to a foreign currency combined with greater volatility of the foreign currency implies greater DEAR.
Dollar loss/gain in currency i
= [Net exposure in foreign currency i measured in U.S. $] × Shock (Volatility) to the $/Foreign currency i exchange rate
Example: October 1998, more than a seven percent one day drop in value of the dollar against the yen.
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FX Trading
FX markets turnover as high as $1.9 trillion per day.
The market moves between Tokyo, NYC and London over the day allowing for what is essentially a 24-hour market.
Growth in electronic FX trading. Overnight exposure adds to the risk. Implication: FIs need dependable measures
of FX exposure.
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Trading Activities
Basically 4 trading activities: Purchase and sale of currencies to complete
international transactions. Facilitating positions in foreign real and financial
investments. Accommodating hedging activities Speculation.
Substantial risk arises via open positions
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Profitability of FX Trading
For large US banks, trading income is a large and growing source of income. Volatility of European currencies are
declining (due to euro). Volatility in Asian and emerging markets
currencies higher but importance of these currencies remains relatively small.
Risk arises from taking open positions in currencies.
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Foreign Assets & Liabilities
Mismatches between foreign asset and liability portfolios
Ability to raise funds from internationally diverse sources presents opportunities as well as risks Greater competition in well-developed (lower
risk) markets
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Return and Risk of Foreign Investments
Returns are affected by: Spread between costs and revenues changes in FX rates
Changes in FX rates are not under the control of the FI Not unlike exposure to interest rate risk
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Risk and Hedging
Hedge can be constructed on balance sheet or off balance sheet. On - balance-sheet hedge will also require
duration matching to control exposure to foreign interest rate risk.
Off-balance-sheet hedge using forwards, futures, or options.
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Multicurrency Positions
Since the banks generally take positions in more than one currency simultaneously, their risk is partially reduced through diversification.
Overall, world bond markets are significantly, but not fully integrated which leaves open the opportunity to reduce exposure by diversifying.
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Diversification Effects (continued)
High correlations between the bond returns may be due to high correlation of real interest rates over time and/or inflation expectations.
ri ≈ rri + iei
Nominal return ≈ real return + E[inflation]
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Fisher Equation*
The actual Fisher equation includes one additional term—cross product of inflation and real interest rate.
ri = rri + iei + (rri × iei )
The last term will matter if inflation and/or real rate is large.
Example: Consider hyperinflations in Brazil and other countries where the inflation rate may be in excess of 100% (or as shown recently in Zimbabwe, even > 4,500%).
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Interest Rate Parity Theorem
Equilibrium condition is that there should be no arbitrage opportunities available through lending and borrowing across currencies. This requires that
1+r(domestic) = (F/S)[1+r (foreign)] Difference in interest rates will be offset by the
expected change in exchange rates. Purchasing power parity:
Exchange rates adjust to reflect inflation rate differences.
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Pertinent Websites
For more information visit:
Federal Reserve Bank www.federalreserve.gov
Citigroup www.citigroup.com
J.P. Morgan Chase www.jpmorganchase.com
U.S. Treasury www.ustreas.gov