Foreign Exchange Risk Chapter 14 © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin

14-2 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.

14-3 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.

14-4 Foreign Exchange Rate Quotes  Price at which one currency can be exchanged for another Direct quote: In the US, this means the price of the foreign currency expressed in US dollars.  Example: US$ per Canadian dollar (C$). Indirect quote: In the US, this means the price of the US dollar in terms of the foreign currency.  Example, C$ per US$.  *Note that the terms direct and indirect, depend on where the quote is obtained. Direct quotes in Canada would be expressed in terms of C$ per unit of foreign currency.

14-5 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

14-6 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) Financial holding companies have even greater ability to reduce their net exposure.

14-7 Trends in FX  Value of foreign positions has increased  Volume of foreign currency trading has decreased  Causes: Corporate and investment bank mergers Increased trading efficiency through technological innovation Introduction of the euro Macroeconomic factors  But, average daily turnover has rebounded Search for yield

14-8  For statistics related to FX trading, visit: Bank for International Settlements Web Resources

14-9 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  Example: October 1998, more than a seven percent one day drop in value of the dollar against the yen.

14-10 FX Trading  FX markets turnover as high as $1.9 trillion per day.  The market moves between Tokyo, NYC and London over the day allowing for what is essentially a 24-hour market.  Growth in electronic FX trading.  Overnight exposure adds to the risk.  Implication: FIs need dependable measures of FX exposure.

14-11 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

14-12 Profitability of FX Trading  For large US banks, trading income is a large and growing 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.

14-13 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

14-14 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

14-15 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.

14-16 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.

14-17 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]

14-18 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 as shown recently in Zimbabwe, even > 4,500%).

14-19 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.  Purchasing power parity: Exchange rates adjust to reflect inflation rate differences.

14-20 Pertinent Websites  For more information visit: Federal Reserve Bank Citigroup J.P. Morgan Chase U.S. Treasury