Chapter 14 Foreign Exchange Risk

Overview Most FIs operate not only nationally, but also globally. FIs provide a range of international operational and currency services. This chapter discusses the risks associated with taking exposures in foreign currencies. We learn about the sources of foreign exchange risk and about the trading of foreign exchange products. We discuss how foreign exchange products impact on the values of global assets and liabilities. We learn about techniques for managing foreign exchange exposures and their hedging. We discuss how interest rates might impact on the value of different currencies. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Sources of Foreign Exchange Risk Exposure Globalisation 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). As of December 2005, Australian FIs had over 50% of foreign assets and liabilities exposures to US markets. From September 1990 to September 2005 the foreign exchange turnover against Australian dollar increased approximately fourfold. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Sources of Foreign Exchange Risk Exposure Major foreign exchange markets: Spot market for foreign exchange (FX): trading for immediate delivery. Forward market for foreign exchange (FX): trading for future delivery. As at February 2007: Swaps: 65%, Options: 2%, Outright spot: 24%, Outright forward: 9%. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Sources of Foreign Exchange Risk Exposure Net exposure of an FI: = (FX assetsi – FX liabilitiesi) + (FX boughti – FX soldi) = Net foreign assetsi + Net FX boughti Where: i = ith currency Net long in a currency: asset holding > liabilities in that currency Net short in a currency: assets < liabilities Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Sources of Foreign Exchange Risk Exposure Value of foreign positions has increased. Volume of foreign currency trading has decreased. Causes: Investment bank mergers, Increased trading efficiency through technological innovation, Introduction of the euro, resulting in reduced volatility. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Foreign Exchange Rate Volatility and FX Exposure Greater exposure to a foreign currency combined with greater volatility of the foreign currency implies greater DEAR. Measurement of potential size of an FI’s FX exposure: Dollar loss/gain in currency i = Net exposure in foreign currency i measured in Australian dollars × shock (volatility) to the $/foreign currency i exchange rate Reason for FX volatility: fluctuations in the demand for and supply of a country’s currency. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Foreign Currency Trading Trading turnovers average $1.8 trillion a day. Largest FX markets: London New York Tokyo Due to different time zones, the FX market is essentially a 24-hour market. Overnight exposure adds to the risk. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

FX Trading Activities Purchase and sale of foreign currencies to: Allow customers to participate in international commercial trade transactions, Allow customers to take positions in foreign investments (real and financial) Hedge exposures in any given currency, Speculate through the anticipation of future movements in FX rates. FI can act as an agent of its customer (fee income). FI can assume FX risk. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

The Profitability of Foreign Currency Trading Most profits and losses come from open transactions. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

The Currency Losses at NAB Example of FX risk. Loss size: $600 million. Group of traders: Exceeded risk limits, Revalued trades for reporting, i.e. made unprofitable trades look profitable, Engaged in fictitious transactions. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Foreign Asset and Liability Positions Risk arises from mismatches between FI’s foreign financial assets and foreign financial liabilities. Ability to raise funds from internationally diverse sources presents opportunities as well as risks: Greater competition in well-developed (lower-risk) markets. The Return and Risk of Foreign Investments: Returns are affected by: Difference between income and cost, Fluctuations in FX rates. Changes in FX rates are not under the control of the FI. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Risk and Hedging On-Balance-Sheet Hedging: Requires duration matching to control exposure to foreign interest rate risk. A direct match of foreign assets and liabilities can result in positive profits for the FI. Off-Balance-Sheet Hedging: Uses forwards, futures, or options. Example: hedging with forwards allows FI to offset uncertainty regarding the future spot rate on a currency. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Interest Rate Parity Theorem (IRPT) The IRPT states that the discounted spread between domestic and foreign interest rates equals the percentage spread between forward and spot exchange rates. Implication: hedging in the forward exchange rate market allows investor to generate same return as in domestic market. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Interest Rate Parity Theorem: Application Assume the interest rate on Australian dollar securities at time t (rDAUD t) equals 5% and the interest rate on Euro loans at time t (rLEUR t) = 10%. Further, suppose the $/€ spot exchange rate (St) at time t is $0.60/€1 and the future exchange rate (Ft) is $0.55/€1. If the spot exchange rate rises to $0.65/ €1, then the forward exchange rate needs to fall by: 1.05 = (1 / 0.65) × (1.10) × Ft and thus: Ft = 1.05 / [(1 / 0.65) × 1.1] = 0.6205 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Multicurrency Foreign Asset–Liability Positions Banks generally take positions in more than one currency simultaneously: Risk reduction through diversification, Reduction of cost of funds. Overall, world bond markets are significantly (but not fully) integrated, which provides the opportunity to reduce exposure through diversification. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Multicurrency Foreign Asset–Liability Positions 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 Where: ri = nominal interest rate in country i, rri = real interest rate in country i, iei = expected one-period inflation rate in country i. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Multicurrency Foreign Asset–Liability Positions Insert Table 14.6 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Foreign Exchange Risk Pertinent web sites: Australian Treasury: www.treasury.gov.au Board of Governors of the Federal Reserve (USA): www.federalreserve.gov Reserve Bank of Australia: www.rba.gov.au Reserve Bank of New Zealand: www.rbnz.govt.nz Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher