BNFN 501 ASSET AND LIABILITY MANAGEMENT

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BNFN 501ASSET AND LIABILITY MANAGEMENT

• WEEK 10
• FOREIGN EXCHANGE RISK
• Sounders and Cornett (2003), Chp 15

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FOREIGN EXCHANGE RISK

• Because of the globalization of the financial
  services industry FIs are increasingly exposed to
  foreign exchange risk
• This chapter evaluates the risks that FIs face
  when their assets and liabilities are denominated
  in foreign (as well as in domestic) currencies
  and when FIs take major positions as traders in
  the spot and forward foreign currency markets.

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• FOREIGN EXCANGE RISK OCCUR IN THE FOLLOWING
  CIRCUMSTANCES
• Trading in foreign currencies
• Making foreign currency loans
• Buying foreign issued securities
• Issuing foreign currency denominated debt as a
  source of funds

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1997 CURRENCY CRISIS IN ASIA

• Some US FIs were adversely impacted. For
  example,in November 1997, Chase Manhattan Corp.
  announced a 160 million loss in October from
  foreign currency trading and holdings of foreign
  currency bonds.

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• SPOT MARKET FOR FX
• The market in which foreign currency is traded
  for immediate delivery
• FORWARD MARKET FOR FX
• The market in which foreign currency is traded
  for future delivery.
• NET EXPOSURE
• The degree to which a bank is net long
  (positive) or net short (negative) in a given
  currency.

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NET EXPOSURE

• A FIs overall FX exposure in any given currency
  can be measured by the net position exposure.
• Net exposure (FX assetsi FX liabilitiesi)
  (FX boughti FX FX Soldi)
• Where i i th currency

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Table 15-2 Weekly US Bank Positions in Foreign
Currencies and Foreign Assets/Liabilities

• Assets Liabilities FX Bought FX Sold
  Net Position
• Canadian 64,301 62,363 377,773 383,869
  -4,158
• Japanese yen 29,381 27,724
  187,776 194,559 -5,126
• Swiss Francs 64,769 70,358 466,789 462,150
  -950
• British Pounds 139,233 126,469
  546,984 549,708 10,040
• Euro 656,005 670,869 2,171,835
  2,193,308 -36,337
• __________________________________________________
  __________
• Figures are in millions
• Includes spot, future and forward contracts
• Net Position (Assets Liabilities ) (FX
  bought EX sold)

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FX RISK EXPOSURE

• A FI could match its foreign currency assets to
  its liabilities in a given currency and match
  buys and sells in its trading book in that
  foreign currency to reduce its foreign exchange
  net exposure to zero and avoid FX risk.
• It could also offset an imbalance in its foreign
  asset-liability portfolio by an opposing
  imbalance in its trading book so that its net
  exposure position in that currency would be zero.

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NET LONG IN A CURRENCY

• A positive net exposure position implies a US FI
  is overall net long in a currency (i.e. the FI
  has bought more foreign currency than it has
  sold) and faces the risk that the foreign
  currency will fall in value against the US
  dollar, the domestic currency.

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NET SHORT IN A FOREIGN CURRENCY

• A negative net exposure position implies that a
  US FI is net short ( i.e. the FI has sold more
  foreign currency than it has purchased) in a
  foreign currency and faces the risk that the
  foreign currency could rise in value against the
  dollar.

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Foreign Exchange Rate Volatility and FX Exposure

• The larger the FI's net exposure in a foreign
  currency and the larger the foreign currency's
  exchange rate volatility, the larger is the
  potential dollar loss or gain to an FI's earnings
  i.e. the greater its daily earnings at risk
  (DEAR)
• FX volatility reflect fluctuations in the demand
  for and supply of a country's currency.

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Loss or gain in Currency i

• Dollar loss/gain in currency i
• Net exposure in foreign currency i measured
  in US dollars x Shock (volatility) to the
  /Foreign currency i exchange rate

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Foreign Currency Trading

• FX markets have become one of the largest of all
  financial markets with trading turn over more
  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.

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FX Trading Activities

• Purchase and sale of currencies to complete
  international transactions
• Facilitating positions in foreign real and
  financial investments
• Accommodating hedging activities
• Speculation
• In the first two FI acts as an agent of its
  customers for a fee therefore it dcesn t assume
  the FX risk itself.

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• Hedging The FI acts defensively as a hedger to
  reduce FX exposure. For example, it may take a
  short (sell) position in the foreign exchange of
  a country to offset a long (buy) position in the
  foreign exchange of that same country.
• Open Position Is an unhedged position in a
  particular currency. FX risk exposure essentially
  relates to open positions taken as a principal by
  the Fl for speculative purposes. Spot currency
  trades are the most common with Fls seeking to
  make a profit on the difference between buy and
  sell prices. However, Fls can also take
  speculative positions in foreign exchange forward
  contracts, futures and options.

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Profitability of Foreign Currency 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

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Foreign Asset and Liability Positions

• In addition to speculations in FX trading, FX
  exposure results from any mismatches between its
  foreign financial asset and foreign financial
  liability portfolios.
• FI is long a foreign currency if its assets in
  that currency exceed its liabilities, while it is
  short a foreign currency if its liabilities in
  that currency exceed its assets.

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The Return and Risk of Foreign Investments

• Like domestic assets and liabilities, profits
  (returns) result from the difference between
  income from and costs paid on a security.
  However, profits (returns) are also affected by
  changes in foreign exchange rates.

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Example 15-1 Calculating the return of foreign
exchange transactions of a US Fl.

• Assets Liabilities
• 100 million US 200 million US
• Loans (one year) CDs (one year)
• in dollars in dollars
• ____________________
• 100 million US equivalent
• UK loans (one year)
• (loans made in sterling)

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Example 15-1 (continues)

• In this example Fl matched the duration of its
  assets and liabilities DA DL( one year)
• Mismatched the currency composition of its asset
  and liability portfolios
• Supposed the 1 year US CD rate is 8
• Supposed the 1 year loan rate in US is 9
• The Fl would have 1 spread from investing
  domestically.
• Supposed the 1 year loan rate in UK is 15

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Example 15-1 (continues)

• To invest in UK, the FI decides to take 50 of
  its 200 m US and make one-year maturity, loans
  in UK.
• Other 50 of the funds are invested in oneyear
  US loans, in US.
• To invest in 100 m US in one year loans
  in UK the US FI engages in the following
  transactions
• 9. At the beginning of the year , sells 100
  million for sterling on the spot currency
  markets. If the exchange rate is 1.60 to 1 ,
  this translates into 100m/1.60 62.5 m sterling.

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Example 15-1 (continues)

• Takes the 62.5 m and makes 1-year UK loans
  at a 15 interest rate
• At the end of the year, revenue from these
  loans will be 62.5m x 1.15 71.875 m
• In order to repatriate these funds back to the US
  at the end of the year, the US FI sells the
• 71.875 m in the foreign exchange market
  at the spot exchange rate that exists at that
  time.

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Example 15-1 (continues)

• Scenario 1 Supposed that spot foreign
  exchange rate remains fixed at 1.60/ 1. Then
  proceeds from the UK investment will be 71.875
  m x 1.60/ 1 115 million The rate of return
  from UK investment
• 115m-100m
• 100,000m
• The weighted return on the bank's portfolio of
  investments would be
• (0.5)(0.09) (0.5)(0.15) 12
• This exceeds the cost of the FIs CDs
• by 4 (12-8)

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• Scenario 2 Suppose that the fell in value
  relative to , or appreciated in value relative
  to . The returns on the UK loans could be far
  less than 15 even the absence of interest rate,
  or credit risk. Suppose the exchange rate had
  fallen from 1.60/ to 1.45/ 1. The pound loan
  revenues at the end of the year would be
• 71.875 m x 1.45/ 1 104.22 m
• The rate of return would be
• 104.22 m - 100 m
• 100 m
• The weiqhted return on the FI's asset
  portfolio would be
• (0.5)(0.09)(0.5)(0.0422)0.06616.61
• In this case Fl has a loss of 6.61 -8
  -1.39

4.22
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• Scenario 3 Suppose the sterling had instead
  appreciated (risen in value) against US over the
  year, such as 1.70/1
• Then the US Fl would generate a dollar return
  from its UK loans of
• 71.875 x 1.70 122.188 m
• Or in percentage return of 22.188

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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 Fl.

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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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On-Balance-Sheet HedgingExample 15-1 Hedging on
the Balance

• __________________________________
• Assets Liabilities
• 100 million US 100 million US
• Loans (9) CDs (8)
• _______________________________________
• 100 million 100
  million
• UK loans (15) UK CDs (11)
• (loan made in ) (deposits
  raised in )
• _______________________________________

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Scenario 1 If the depreciates in value against
the from 1.60/ 1 to 1.45/ 1, at the end of
the year.

• Beginning of the year bank borrows 100 m
  equivalent CDs, with 11 interest rates. 100
  m/1.6 62.5 m
• End of the year bank pays back 62.5x1.1169.375m
  
• End of the year exchange rate becomes 1.45/ 1
  the repayment in terms of becomes
• 69.375 m x 1.45/ 1 100.59 m, Instead
  of
• 69.375 m x 1.60/ 1 111.00 m

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• Average return on assets
• (0.5)(0.9) (0.5)(0.422) 6.61
• US asset return UK asset return overall return
• Average cost of funds
• (0.5)(0.08) (0.5)(0.0059) 0.0434.295
• US cost of funds UK cost of funds overall cost
• Net return
• Average return on assets - average cost of funds
  
• 6.61-4.2952.315

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• Scenario 1 If the appreciates in value
  against the from 1.60/ 1 to 1.70/ 1, at the
  end of the year.
• 69.375 m x 1.70/ 1 117.9375 m
• The cost of funds of 17.9375
• Average return on assets
• (0.5)(0 09) (0.5)(0. 22188) 0.15594 or
  15.594
• Average cost of funds
• (0.5)(0.08) (0.5)(0.179375) 0.12969 or
  12.969
• Net return1 5.594 -12.969 2.625

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Hedging with Forwards (Off-BalanceSheet Hedging)

• Instead of matching its 100 m foreign asset
  position with 100 million of foreign
  liabilities, the FI might have chosen to remain
  unhedged on the balance sheet. Instead as a lower
  cost alternative, it could hedge by taking a
  position in the forward market for foreign
  currencies.

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• Forward-Exchange Contract
• An agreement to purchase foreign exchange at
  a specified date in the future at an agreed
  exchange
• Option Forward Contract
• If the buyer of the currency is uncertain of
  the future date and the amount of the currency
  involved, he may use an option forward contract,
  in which the buyer of the contract receive the
  right nut not the obligation to deliver or take
  delivery of specific currencies on a future date
  at an agreed upon exchange rate.
• Forward Exchange Rate
• The exchange rate agreed to today for future
  (forward) delivery of a currency

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Using the Forwards in Example 15-1and Example
15-2

• Instead of waiting until the end of the year,
  to transfer sterling back into dollars at an
  unknown spot rate, the Fl can enter into a
  contract to sell forward its expected principal
  and interest earnings on the loan, at today's
  known forward exchange rate for dollars/pounds,
  with delivery of sterling funds to the buyer of
  the forward contract taking place at the end of
  the year.
• By selling the expected proceeds on the
  sterling loan forward, at a known (forward FX)
  exchange rate today the Fl removes the future
  spot exchange rate uncertainty and thus the
  uncertainty relating to investment returns on the
  British loan.

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Interest Rate Parity Theorem

• In general, spot rates and forward rates for
  a given currency differ. The forward exchange
  rate is determined by the spot exchange rate and
  the interest rate differential between the two
  countries. The specific relationship that links
  spot exchange rates, interest rates, and forward
  exchange rates is described as the interest rate
  parity theorem (IRPT). The IRPT implies that by
  hedging in the forward exchange rate market, an
  investor realizes the same returns whether
  investing domestically or in a foreign country
  that is the hedged dollar return on foreign
  investments just equals the return on domestic
  investments.

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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.