Foreign Exchange Risk Chapter 15 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. K. R. Stanton

McGraw-Hill/Irwin 15-2 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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.

McGraw-Hill/Irwin 15-3 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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.

McGraw-Hill/Irwin 15-4 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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

McGraw-Hill/Irwin 15-5 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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)

McGraw-Hill/Irwin 15-6 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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

McGraw-Hill/Irwin 15-7 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.  For statistics related to FX trading, visit: Bank for International Settlements Web Resources

McGraw-Hill/Irwin 15-8 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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  Current issues related to falling value of the dollar against yen and euro

McGraw-Hill/Irwin 15-9 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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.  Implication: FIs need dependable measures of FX exposure.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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 but importance of these currencies remains relatively small Risk arises from taking open positions in currencies

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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] *Note that this is only an approximation.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Fisher Equation* The actual Fisher equation includes one additional term—cross product of inflation and real interest rate. r i = rr i + i e i + (rr i × i e i ) 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 even >1000%).

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Pertinent Websites  For more information visit: Federal Reserve Bank Citigroup J.P. Morgan Chase U.S. Treasury