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BANK 501 ASSET AND LIABILITY MANAGEMENT

BANK 501 ASSET AND LIABILITY MANAGEMENT. WEEK 8 FOREIGN EXCHANGE RISK Sounders and Cornett (2006), Chp 15. FOREIGN EXCHANGE RISK. Because of the globalization of the financial services industry FIs are increasingly exposed to foreign exchange risk

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BANK 501 ASSET AND LIABILITY MANAGEMENT

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  1. BANK 501ASSET AND LIABILITY MANAGEMENT WEEK 8 FOREIGN EXCHANGE RISK Sounders and Cornett (2006), Chp 15

  2. 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.

  3. 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

  4. 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.

  5. 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.

  6. 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

  7. 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)

  8. 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.

  9. 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.

  10. 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.

  11. 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.

  12. 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

  13. 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.

  14. 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.

  15. 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 exchangeforward contracts, futures and options.

  16. 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

  17. 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.

  18. 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.

  19. 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)

  20. 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%

  21. 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.

  22. 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.

  23. 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 FI’s CD’s by 4% (12%-8%) =15%

  24. 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)=0.0661=6.61% In this case Fl has a loss of 6.61% -8% = -1.39% = 4.22%

  25. 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%

  26. 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.

  27. 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.

  28. 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 £) _______________________________________

  29. 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 £62.5x1.11=£69.375m • 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

  30. 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) =0.043=4.295% US cost of funds UK cost of funds =overall cost Net return: Average return on assets - average cost of funds 6.61%-4.295%=2.315%

  31. 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%

  32. 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.

  33. 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

  34. 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 Flcan 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 theyear. 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.

  35. 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.

  36. 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.

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