Drake DRAKE UNIVERSITY Fin 286 International Risk Management

Drake Drake University Fin 286 Introduction This portion of the class covers portions of three different chapters in the book, chapters 15, 16 and 23. This issue has become increasingly important for FIs due to hedging needs and speculative positions taken to increase income.

Drake Drake University Fin 286 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.

Drake Drake University Fin 286 Sources of FX Risk Spot positions denominated in foreign currency Forward positions denominated in foreign currency Net exposure in currency i = (FX assets i - FX liab i ) + (FX bought i - FX sold i ) Net long (+) Net Short (-)

Drake Drake University Fin 286 FX Risk Exposure Could match foreign currency assets and liabilities to hedge F/X risk, but that is not enough Must also hedge against foreign interest rate risk (by matching durations, for example)

Drake Drake University Fin 286 Trends in FX 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

Drake Drake University Fin 286 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

Drake Drake University Fin 286 FX Trading FX markets turnover often greater than $1.8 trillion per day. The market moves between Tokyo, NYC and London over the day allowing for what is essentially a 24-hour market. Overnight exposure adds to the risk.

Drake Drake University Fin 286 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.

Drake Drake University Fin 286 Profitability of FX Trading For large US banks, trading income is a major source of income. Volatility of European currencies are declining (due to euro) Volatility in Asian and emerging markets currencies higher Risk arises from taking open positions in currencies

Drake Drake University Fin 286 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

Drake Drake University Fin 286 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

Drake Drake University Fin 286 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.

Drake Drake University Fin 286 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.

Drake Drake University Fin 286 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.

Drake Drake University Fin 286 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. r i = rr i + i e i Nominal return = real return + E[inflation]

Drake Drake University Fin 286 Sovereign Risk (chapter 16) In 1970s: Expansion of loans to Eastern bloc, Latin America and other LDCs. Beginning of 1980s: Poland and Eastern bloc repayment problems. Debt moratoria announced by Brazil and Mexico. Increased loan loss reserves

Drake Drake University Fin 286 Introduction (continued) Late 1980s and early 1990s: Expanding investments in emerging markets. Peso devaluation. More recently: Asian and Russian crises. MYRAs Brady Bonds

Drake Drake University Fin 286 Credit Risk versus Sovereign Risk Sovereign Risk -- Governments can impose restrictions on debt repayments to outside creditors. Loan may be forced into default even though borrower had a strong credit rating at origination of loan. Legal remedies are very limited. Need to assess credit quality and sovereign risk

Drake Drake University Fin 286 Sovereign Risk Debt repudiation – cancellation of current and future debt obligations Since WW II, only China, Cuba and North Korea have repudiated debt. Rescheduling –moratorium or delay in payments of a country or group of creditors in a country Most common form of sovereign risk.

Drake Drake University Fin 286 Debt Rescheduling More likely with debt financing rather than bond financing Loan syndicates often comprised of same group of Fis probability of agreement increases Cross-default provisions state that one default constitutes default in entire portfolio Specialness of banks argues for rescheduling but, incentives to default again if bailouts are automatic

Drake Drake University Fin 286 Country Risk Evaluation Outside evaluation models: The Euromoney Index The Economist Intelligence Unit ratings – higher the rating greater the risk Based upon both economic and political risks. Institutional Investor Index

Drake Drake University Fin 286 Country Risk Evaluation Internal Evaluation Models Statistical models: Country risk-scoring models based on primarily economic ratios.

Drake Drake University Fin 286 Statistical Models Commonly used economic ratios: Debt service ratio: (Interest + amortization on debt)/Exports Import ratio: Total imports / Total FX reserves Investment ratio: Real investment / GNP Variance of export revenue Domestic money supply growth

Drake Drake University Fin 286 Problems with Statistical CRA Models Measurements of key variables. Population groups Finer distinction than reschedulers and nonreschedulers may be required. Political risk factors Strikes, corruption, elections, revolution. Portfolio aspects

Drake Drake University Fin 286 Problems with Statistical CRA Models (continued) Incentive aspects of rescheduling: Borrowers and Lenders: Benefits Costs Stability Model likely to require frequent updating.

Drake Drake University Fin 286 Mechanisms for Dealing with Sovereign Risk Exposure Debt-equity swaps Example: Citibank sells $100 million Chilean loan to Merrill Lynch for $91 million. Merrill Lynch (market maker) sells to IBM at $93 million. Chilean government allows IBM to convert the $100 million face value loan into pesos at a discounted rate to finance investments in Chile.

Drake Drake University Fin 286 Multi Year restructuring agreements MYRAs Aspects of MYRAs: Fee charged by bank for restructuring Interest rate charged Grace period Maturity of loan Option features Concessionality

Drake Drake University Fin 286 Other Mechanisms Loan Sales Bond for Loan Swaps (Brady bonds) Transform LDC loan into marketable liquid instrument. Usually senior to remaining loans of that country.

Drake Drake University Fin 286 Geographic Diversification Chapter 23 Although many FIs can diversify domestically, the benefits to global diversification are available only to large firms. This chapter explores the potential risk-return advantages and disadvantages of international expansion and the trends toward globalization of FI franchises. As countries such as the U.S. expand, some countries, Japan in particular, are contracting their overseas operations.

Drake Drake University Fin 286 Global and International Expansions Three ways to establish global presence Sell financial services from domestic offices to foreign customers Sell financial services through a branch, agency, or representative office in foreign customer’s country Sell financial services through subsidiary company in foreign customer’s country.

Drake Drake University Fin 286 Global Expansion of FIs U.S. insurance companies and securities firms recent expansion 12 banks in the world with over 50 percent of assets in foreign countries No single country dominates Japanese banks absent in spite of their size

Drake Drake University Fin 286 U.S. Banks Abroad J.P. Morgan/Chase have had offices abroad since beginning of century. Major growth began in 1960s Overseas Direct Investment Control Act, Offshore funding and lending in dollars forged beginnings of the Eurodollar market. Assets of U.S. bank activities abroad increased from $353.8 billion in 1980, to $745 billion in Declined in percentage terms.

Drake Drake University Fin 286 Factors Encouraging U.S. Bank Expansions Abroad Dollar as international medium of exchange Effects of Euro Political risk Encouraged flows to U.S. branches and subsidiaries in Cayman Islands and Bahamas. USA Patriot Act of 2001 prohibited services to shell banks and increased focus on money laundering

Drake Drake University Fin 286 Factors Encouraging U.S. Bank Expansions Abroad Domestic activity restrictions Fed regulations permitting banks to engage in activities permitted by foreign host. Diversification benefits. Technology and communications improvements CHIPS Decreasing operating costs

Drake Drake University Fin 286 Factors Deterring Expansion Capital constraints BIS 2001 reforms raise capital requirements for loans to non- OECD sovereigns rated below B- raise capital requirements for loans to OECD countries rated below AA- zero risk weights for OECD countries rated above AA-

Drake Drake University Fin 286 Factors Deterring Expansion Emerging markets problems Increased caution due to Korea, Thailand, Indonesia despite improved regulatory environment (NAFTA, for example). WTO reduction of barriers to global expansion China as a recent noteworthy example

Drake Drake University Fin 286 Factors Deterring Expansion Competition During 1990s, extensive competition from Japanese banks Japan had 9 of the 10 largest banks European Community Second Banking Directive resulted in significant consolidation of European banks.

Drake Drake University Fin 286 Foreign Banks in the U.S. Organizational form Subsidiary Branch Agency Edge Act Corporation Representative Office

Drake Drake University Fin 286 Trends and Growth Rapid expansion of foreign banks in U.S. In 1980, foreign banks had assets of $166.7 billion (10.8 percent of total U.S. bank assets) 1992, $514.3 billion (16.4 percent) 1994, $471.1 billion (13.8 percent) Retrenchments due to several factors including competitive and regulatory effects. Recent growth in foreign bank operations in U.S.

Drake Drake University Fin 286 Regulation of Foreign Banks in U.S. Prior to 1978, foreign branches and agencies were licensed mostly at state level. No access to discount window No direct access to Fedwire/fed funds markets No FDIC coverage

Drake Drake University Fin 286 Regulation of Foreign Banks in U.S. (post 1978) Passage of International Banking Act, 1978 National treatment to level the playing field Accelerated expansion of foreign banks in U.S. Japanese bank entry into California, and subsequent sales notable

Drake Drake University Fin 286 Regulation of Foreign Banks Foreign Bank Supervision Enhancement Act 1991, increased federal control. Triggered by three events: collapse of BCCI issuance of $1 billion in unauthorized letters of credit to Iraq by Atlanta agency of Banca Nazionale del Lavoro unauthorized taking of deposit funds by U.S. representative of Greek National Mortgage Bank of New York.

Drake Drake University Fin 286 Features of FBSEA Fed’s approval required for entry Closure under control of Federal Reserve Daiwa Bank ordered to cease operations. Examination by Fed Deposits: Only foreign subsidiaries with FDIC coverage can take deposits under $100,000. Activity powers: restricted to activities permitted to federal branch.

Drake Drake University Fin 286 Advantages to International Expansion Risk diversification Economies of scale Innovations generate extra returns from selling new products abroad. Funds source Customer relationships Regulatory avoidance

Drake Drake University Fin 286 Disadvantages Information/monitoring costs Example: differences in accounting standards Nationalization/expropriation. Fixed costs may be high Tokyo real estate prices for example.