P1.T3. Financial Markets & Products Anthony Saunders and Marcia Millon Cornett, Financial Institutions Management: A Risk Management Approach

P1.T3. Financial Markets & Products Anthony Saunders and Marcia Millon Cornett, Financial Institutions Management: A Risk Management Approach

P1.T3. Financial Markets & Products Anthony Saunders and Marcia Millon Cornett, Financial Institutions Management: A Risk Management Approach Foreign Exchange Risk Bionic Turtle FRM Video Tutorials By David Harper, CFA FRM

P1.T3. Financial Markets & Products Anthony Saunders and Marcia Millon Cornett, Financial Institutions Management: A Risk Management Approach
  • Foreign Exchange Risk Page 2
  • Calculate a financial institution’s overall foreign exchange exposure.
  • Explain how a financial institution could alter its net position exposure to reduce foreign exchange risk.
  • Calculate a financial institution’s potential dollar gain or loss exposure to a particular currency.
  • Identify and describe the different types of foreign exchange trading activities.
  • Identify the sources of foreign exchange trading gains and losses. - continued on next page -
P1.T3. Financial Markets & Products Anthony Saunders and Marcia Millon Cornett, Financial Institutions Management: A Risk Management Approach
  • Foreign Exchange Risk (continued) Page 3
  • Calculate the potential gain or loss from a foreign currency denominated investment.
  • Explain balance‐sheet hedging with forwards.
  • Describe how a non‐arbitrage assumption in the foreign exchange markets leads to the interest rate parity theorem; use this theorem to calculate forward foreign exchange rates.
  • Explain why diversification in multicurrency asset‐liability positions could reduce portfolio risk.
  • Describe the relationship between nominal and real interest rates.
P1.T3. Financial Markets & Products Anthony Saunders and Marcia Millon Cornett, Financial Institutions Management: A Risk Management Approach
  • Calculate a financial institution’s overall foreign exchange exposure. Page 4 An FI’s overall FX exposure in any given currency can be measured by the net position exposure, which is measured in local currency as
  • Positive net exposure ⇒ net long a currency.
  • Negative net exposure ⇒ net short a currency.
  • A positive net exposure position implies a U.S. 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 U.S. dollar, the domestic currency.

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

P1.T3. Financial Markets & Products Anthony Saunders and Marcia Millon Cornett, Financial Institutions Management: A Risk Management Approach

Calculate a financial institution’s overall foreign exchange exposure. Page 5 The table below replicates Saunders’ Table 13-3. The net position of each currency is the sum of (assets minus liabilities) and (FX Bought minus FX Sold). For example, in the case of Japanese yen (59,620 - 54,591) + (471,248 - 481,227) = -4,950.

P1.T3. Financial Markets & Products Anthony Saunders and Marcia Millon Cornett, Financial Institutions Management: A Risk Management Approach
Explain how a financial institution could alter its net position exposure to reduce foreign exchange risk. Page 6 To reduce its foreign currency exposure:
  • An 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 thus avoid FX risk.
  • An 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 thus avoid FX risk.
  • FIs 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.
  • FIs 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.
  • Financial holding companies can aggregate their foreign exchange exposure even more. Financial holding companies might have a commercial bank, an insurance company, and a pension fund all under one umbrella that allows them to reduce their net foreign exchange exposure across all units.
  • Financial holding companies can aggregate their foreign exchange exposure even more. Financial holding companies might have a commercial bank, an insurance company, and a pension fund all under one umbrella that allows them to reduce their net foreign exchange exposure across all units.
P1.T3. Financial Markets & Products Anthony Saunders and Marcia Millon Cornett, Financial Institutions Management: A Risk Management Approach

Calculate a financial institution’s potential dollar gain or loss exposure to a particular currency. Page 7 We can measure the potential size of an FI’s FX exposure by analyzing the asset, liability, and currency trading mismatches on its balance sheet and the underlying volatility of exchange rate movements. Specifically, the potential size of a bank’s FX exposure given by: = [ $] × $/ = [ $] × $/ 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. The underlying causes of FX volatility reflect fluctuations in the demand for and supply of a country’s currency.

That is, an FX rate is like the price of any good and will appreciate in value relative to other currencies when demand is high or supply is low and will depreciate in value when demand is low or supply is high.

P1.T3. Financial Markets & Products Anthony Saunders and Marcia Millon Cornett, Financial Institutions Management: A Risk Management Approach

Identify and describe the different types of foreign exchange trading activities. Page 8 A bank’s position in the FX markets generally reflects four trading activities. It involves the purchase and sale of foreign currencies: 1. To allow customers to complete international commercial trade transactions. 2. To allow customers (or the FI itself) to take positions in foreign real and financial investments. 3. For hedging purposes to offset customer (or FI) exposure in any given currency. 4. For speculative purposes, to forecast or anticipate future movements in FX rates.

P1.T3. Financial Markets & Products Anthony Saunders and Marcia Millon Cornett, Financial Institutions Management: A Risk Management Approach
  • Identify the sources of foreign exchange trading gains and losses. Page 9
  • In the first two activities shown on the previous slide (to allow customers to participate in international commercial trade transactions; and to allow customers to take positions in foreign investments, real or financial assets), the FI normally acts as an agent of its customers for a fee but does not assume the FX risk itself.
  • In the third activity, the FI acts defensively as a hedger to reduce FX exposure. For example, an FI 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.

Consequently, the FX risk exposure essentially relates to open positions taken as a principal by the FI for speculative purposes, the fourth activity. An FI usually creates an open position by taking an unhedged position in a foreign currency in its FX trading with other FIs.

P1.T3. Financial Markets & Products Anthony Saunders and Marcia Millon Cornett, Financial Institutions Management: A Risk Management Approach
  • Identify the sources of foreign exchange trading gains and losses (continued) Page 10 FIs can make speculative trades directly with other FIs or arrange them through specialist FX brokers.
  • The Federal Reserve Bank of New York estimates that approximately 45 % of speculative or open position trades are accomplished through specialized brokers who receive a fee for arranging trades between FIs.
  • Speculative trades can be instituted through a variety of FX instruments. Spot currency trades are the most common, with FIs seeking to make a profit on the difference between buy and sell prices. However, FIs can also take speculative positions in foreign exchange forward contracts, futures, and options.

Most profits or losses on foreign trading come from taking an open position or speculating in currencies. Revenues from market making—the bid–ask spread— or from acting as agents for retail or wholesale customers generally provide only a secondary or supplementary revenue source.

Calculate the potential gain or loss from a foreign currency denominated investment. Page 11 Baseline Scenario: Un-hedged Balance Sheet is exposed to FX Risk. In this scenario (Saunders Example 13-1), the U.S. FI raises all of its $200 million liabilities in dollars (one-year CDs) but invests 50% in U.S.

dollar assets (one-year maturity loans) and 50% in U.K. pound assets (one-year maturity loans). We assume the FI has matched the duration of its assets and liabilities ( = = 1 year) but has mismatched the currency composition of its asset and liability portfolios. Suppose the promised one-year U.S. CD rate is 8.0%, to be paid in dollars at the end of the year, and that one-year, default risk–free loans in the United States are yielding 9.0%. The FI would have a positive spread of 1.0% from investing domestically. Suppose, however, that default risk–free, oneyear loans are yielding 15.0% in the United Kingdom.

Calculate the potential gain or loss from a foreign currency denominated investment (continued) Page 12 To invest in the United Kingdom, the FI decides to take 50.0% of its $200 million in funds and make one-year maturity U.K. pound loans while keeping 50.0% of its funds to make U.S. dollar loans. To invest $100 million (of the $200 million in CDs issued) in one-year loans in the United Kingdom, the U.S. FI engages in the following transaction:
  • At the beginning of the year, sells $100 million for pounds on the spot currency markets. If the exchange rate is $1.60 to £1, this translates into $100 million/1.6 = £62.5 million.
  • Takes the £62.5 million and makes one-year U.K. loans at a 15.0% interest rate.
  • At the end of the year, pound revenue from these loans will be £62.5 × 1.15 = £71.875 million.
  • Repatriates these funds back to the United States at the end of the year. That is, the U.S. FI sells the £71.875 million in the foreign exchange market at the spot exchange rate that exists at that time, the end of the year spot rate.
  • Calculate the potential gain or loss from a foreign currency denominated investment (continued) Page 13 First unhedged scenario: suppose the spot foreign exchange rate does not change over the year: it remains fixed at $1.60/£1. Then the dollar proceeds from the U.K. investment will be: £71.875 million × $1.60 / £1 = $115 million.
  • This can be shown as a return of (115 million -100 million) / 100 million = 15.0%
  • Given this, the weighted return on the bank’s portfolio of investments would be:
  • (0.5) (0.09) + (0.5) (0.15) = 0.12 or 12%.

This exceeds the cost of the FI’s CDs by 4% (12% - 8%). See exhibit here.

Calculate the potential gain or loss from a foreign currency denominated investment (continued) Page 14

Calculate the potential gain or loss from a foreign currency denominated investment (continued) Page 15 Second unhedged scenario (foreign currency depreciation erodes unhedged returns): Suppose, however, that at the end of the year the British pound falls in value relative to the dollar, or the U.S. dollar appreciates in value relative to the pound.

The return on the U.K. loans could be far less than 15.0% even in the absence of interest rate or credit risk. For example, suppose the exchange rate falls from $1.60/£1 at the beginning of the year to $1.45/£1 at the end of the year when the FI needs to repatriate the principal and interest on the loan.

At an exchange rate of $1.45/£1, the pound loan revenues at the end of the year translate into:
  • £71.875 million × $1.45/£1 = $104.22 million
  • This expressed as a return on the original dollar investment is: ($ 104.22 - $ 100 $ 100 = 0.0422 = 4.22%
  • The weighted return on the FI’s asset portfolio would be: (0.5) (0.09) + (0.5) (0.0422) = 0.0661 = 6.61%
  • In this case, the FI actually has a loss or has a negative interest margin on its balance sheet investments: (6.61% - 8% = -1.39%)

Calculate the potential gain or loss from a foreign currency denominated investment (continued) Page 16

  • Calculate the potential gain or loss from a foreign currency denominated investment (continued) Page 17 On balance-sheet hedging In principle, an FI manager can better control the scale of its FX exposure in two major ways: on-balance-sheet hedging and off-balance-sheet hedging.
  • On balance-sheet hedging involves making changes in the on-balance-sheet assets and liabilities to protect FI profits from FX risk.
  • Off-balance-sheet hedging involves no on-balance-sheet changes, but rather involves taking a position in forward or other derivative securities to hedge FX risk.

Calculate the potential gain or loss from a foreign currency denominated investment (continued) Page 18 The following example illustrates how an FI manager can control FX exposure by making changes on the balance sheet. Suppose, as seen in the earlier example that instead of funding the $100 million investment in 15.0% British loans with U.S. CDs, the FI manager funds the British loans with $100 million equivalent one-year pound CDs at a rate of 11.0% as illustrated below. In this situation, the FI has both a matched maturity and currency foreign asset–liability book. We might now consider the FI’s profitability or spread between the return on assets and the cost of funds under two scenarios: first, when the pound depreciates in value against the dollar over the year from $1.60/£1 to $1.45/£1 and second, when the pound appreciates in value over the year from $1.60/£1 to $1.70/£1.

Calculate the potential gain or loss from a foreign currency denominated investment (continued) Page 19 The Depreciating Pound (under on balance-sheet hedging): When the pound falls in value to $1.45/£1, the return on the British loan portfolio is 4.22%. Consider now what happens to the cost of $100 million in pound liabilities in dollar terms: 1. At the beginning of the year, the FI borrows $100 million equivalent in pound CDs for one year at a promised interest rate of 11.0%. At an exchange rate of $1.60£, this is a pound equivalent amount of borrowing of $100 million/1.6 = £62.5 million.

2. At the end of the year, the bank has to pay back the pound CD holders their principal and interest, £62.5 million (1.11) = £69.375 million. 3. If the pound depreciates to $1.45/£1 over the year, the repayment in dollar terms would be £69.375 million × $1.45/£1 = $100.59 million, or a dollar cost of funds of 0.59%.

Calculate the potential gain or loss from a foreign currency denominated investment (continued) Page 20 Thus, at the end of the year the following occurs: Average return on assets: (0.5) (0.09) + (0.5) (0.0422) = 0.0661 = 6.61% U.S. asset return U.K. asset return Overall return Average cost of funds: (0.5) (0.08) + (0.5) (0.0059) = 0.04295 = 4.295% U.S. cost of funds U.K. cost of funds Overall cost Net return: Average return on assets - Average cost of funds 6.61% - 4.295% = 2.315%

Calculate the potential gain or loss from a foreign currency denominated investment (continued) Page 21

Calculate the potential gain or loss from a foreign currency denominated investment (continued) Page 22 The Appreciating Pound (under on balance-sheet hedging): When the pound appreciates over the year from $1.60/£1 to $1.70/£1, the return on British loans is equal to 22.188%. Now consider the dollar cost of British one-year CDs at the end of the year when the U.S. FI has to pay the principal and interest to the CD holder: £69.375million × $1.70/£1 = $117.9375 million or a dollar cost of funds of 17.9375 %.

  • Thus, at the end of the year, average return on assets is: (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 return: 15.594 -12.969 = 2.625%

Explain balance‐sheet hedging with forwards. Page 23 Off-balance sheet hedging As a lower-cost alternative, the FI could hedge by taking a position in the forward market for foreign currencies. Any forward position would be as a contingent offbalance-sheet claim (an item below the bottom line) and would not appear on the balance sheet. The role of the forward FX contract is to offset the uncertainty regarding the future spot rate on pounds at the end of the one-year investment horizon. Instead of waiting until the end of the year to transfer pounds back into dollars at an unknown spot rate, the FI 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 pound funds to the buyer of the forward contract taking place at the end of the year.

Essentially, by selling the expected proceeds on the pound loan forward, at a known (forward FX) exchange rate today, the FI removes the future spot exchange rate uncertainty and thus the uncertainty relating to investment returns on the British loan.

Explain balance‐sheet hedging with forwards (continued) Page 24 Consider the following transactions when the FI hedges its FX risk immediately by selling its expected one-year pound loan proceeds in the forward FX market which is illustrated below.

Explain balance‐sheet hedging with forwards (continued) Page 25 1. The U.S. FI sells $100 million for pounds at the spot exchange rate today and receives $100 million/1.6 = £62.5 million. 1. The U.S. FI sells $100 million for pounds at the spot exchange rate today and receives $100 million/1.6 = £62.5 million.

4. In one year, the British borrower repays the loan to the FI plus interest in pounds (£71.875 million). 4. In one year, the British borrower repays the loan to the FI plus interest in pounds (£71.875 million).

2. FI immediately lends the £62.5 million to a British customer at 15.0% for one year. 2. FI immediately lends the £62.5 million to a British customer at 15.0% for one year. 3. The FI also sells the expected principal and interest proceeds from the pound loan forward for dollars at today’s forward rate for one-year delivery. Let the current forward one-year exchange rate between dollars and pounds stand at $1.55/£1, or at a 5 cent discount to the spot pound; as a percentage discount: ($1.55 - $1.60)/$1.6 = - 3.125% This means that the forward buyer of pounds promises to pay: £62.5 million (1.15) × $1.55 / £1 = £71.875million × $1.55 / £1 = $111.406million to the FI (the forward seller) in one year when the FI delivers the £71.875 million proceeds of the loan to the forward buyer.

3. The FI also sells the expected principal and interest proceeds from the pound loan forward for dollars at today’s forward rate for one-year delivery. Let the current forward one-year exchange rate between dollars and pounds stand at $1.55/£1, or at a 5 cent discount to the spot pound; as a percentage discount: ($1.55 - $1.60)/$1.6 = - 3.125% This means that the forward buyer of pounds promises to pay: £62.5 million (1.15) × $1.55 / £1 = £71.875million × $1.55 / £1 = $111.406million to the FI (the forward seller) in one year when the FI delivers the £71.875 million proceeds of the loan to the forward buyer.

5. The FI delivers the £71.875 million to the buyer of the one-year forward contract and receives the promised $111.406 million. 5. The FI delivers the £71.875 million to the buyer of the one-year forward contract and receives the promised $111.406 million.

  • Explain balance‐sheet hedging with forwards (continued) Page 26
  • Barring the pound borrower’s default on the loan or the forward buyer’s reneging on the forward contract, the FI knows from the very beginning of the investment period that it has locked in a guaranteed return on the British loan of: ($111.406 - $100)/ $100 = 0.11406 = 11.406%
  • Specifically, this return is fully hedged against any dollar/pound exchange rate changes over the one-year holding period of the loan investment. Given this return on British loans, the overall expected return on the FI’s asset portfolio is: (0.5) (0.09) + (0.5) (0.11406) = 0.10203 or 10.203%
  • Since the cost of funds for the FI’s $200 million U.S. CDs is an assumed 8%, it has been able to lock in a risk-free return spread over the year of 2.203% regardless of spot exchange rate fluctuations between the initial foreign (loan) investment and repatriation of the foreign loan proceeds one year later.

Describe how a non‐arbitrage assumption in the foreign exchange markets leads to the interest rate parity theorem; use this theorem to calculate forward foreign exchange rates. Page 27 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).

Intuitively, 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.

This is a so-called no-arbitrage relationship in the sense that the investor cannot make a risk-free return by taking offsetting positions in the domestic and foreign markets. That is, the hedged dollar return on foreign investments just equals the return on domestic investments. The eventual equality between the cost of domestic funds and the hedged return on foreign assets, or the IRPT, can be expressed as: ×

Describe how a non‐arbitrage assumption in the foreign exchange markets leads to the interest rate parity theorem; use this theorem to calculate forward foreign exchange rates (continued). Page 28 Rate on U.S. investment = Hedged return on foreign (U.K.) investment 1 + = 1 plus interest rate on US CDs for the FI at time t £ spot exchange rate at time plus interest rate on UK CDs at time t £ forward exchange at time t Thus, the IRPT is motivated by arbitrage arguments: if interest rates are higher in, say the UK, than in the US, it is attractive for investors to invest in UK assets, earning a higher rate of return.

If US investors borrow USD to buy Pound Sterling denominated CDs, the cost of Pound Sterling in terms of USD appreciates (becomes more expensive). As the spot price increases, the forward exchange rate simultaneously decreases. Thus, it becomes less attractive to but Pound Sterling denominated CDs as you get fewer Pounds per USD, and you know that the exchange rate one year from now will be lower (you will receive less for your Pound Sterling). These forces will ensure that Covered Interest Rate Parity holds, with any deviation quickly being seized upon by arbitrageurs.

Describe how a non‐arbitrage assumption in the foreign exchange markets leads to the interest rate parity theorem; use this theorem to calculate forward foreign exchange rates (continued). Page 29 Saunders Example 13-5: An application of Interest Rate Parity Theorem Suppose = 8% and = 11%, as in our preceding example. As the FI moves into more British CDs, suppose the spot exchange rate for buying pounds rises from $1.60/£1 to $1.63/£1. In equilibrium, the forward exchange rate would have to fall to $1.5859/£1 to eliminate completely the attractiveness of British investments to the U.S. FI manager.

That is: (1.08) = (1/ 1.63) [1.11] (1.5859)

Describe how a non‐arbitrage assumption in the foreign exchange markets leads to the interest rate parity theorem; use this theorem to calculate forward foreign exchange rates (continued). Page 30 This is a no-arbitrage relationship in the sense that the hedged dollar return on foreign investments just equals the FI’s dollar cost of domestic CDs. Rearranging, the IRPT can be expressed as: 0.08 − 0.11 1.11 ≈ 1.5859 − 1.63 1.63 −0.0270 ≈ −0.0270 That is, the discounted spread between domestic and foreign interest rates is approximately equal to the percentage spread between forward and spot exchange rates.

Explain why diversification in multicurrency asset‐liability positions could reduce portfolio risk. Page 31 So far, we have used a one-currency example of a matched or mismatched foreign asset–liability portfolio. Many FIs, including banks, mutual funds, and pension funds, hold multicurrency asset–liability positions. As for multicurrency trading portfolios, diversification across many asset and liability markets can potentially reduce the risk of portfolio returns and the cost of funds. To the extent that domestic and foreign interest rates or stock returns for equities do not move closely together over time, potential gains from asset– liability portfolio diversification can offset the risk of mismatching individual currency asset–liability positions.

  • Describe the relationship between nominal and real interest rates. Page 32 Theoretically speaking, the one-period nominal interest rate ( ) on fixed income securities in any particular country has two major components.
  • First, the real interest rate reflects underlying real sector demand and supply for funds in that currency.
  • Second, the expected inflation rate reflects an extra amount of interest lenders demand from borrowers to compensate the lenders for the erosion in the principal (or real) value of the funds they lend due to inflation in goods prices expected over the period of the loan. = + = Nominal interest rate in country i = real interest rate in country i = expected one-period inflation rate in country i Nominal interest rate ≅ real interest rate + [expected] inflation rate. This can also be defined slightly more mathematically precise as so, Nominal interest rate = [(1 + real interest rate) x (1 + expected inflation)] -1.

The End P1.T3. Financial Markets & Products Anthony Saunders and Marcia Millon Cornett, Financial Institutions Management: A Risk Management Approach Foreign Exchange Risk

You can also read
Next part ... Cancel