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Foreign Exchange Risk Chapter 15 Financial Institutions Management, 3/e By Anthony Saunders Background Globalization of financial markets has increased foreign exposure of most FIs.

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foreign exchange risk chapter 15

Foreign Exchange RiskChapter 15

Financial Institutions Management, 3/e

By Anthony Saunders

background
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.
  • Net exposure = (FX assets - FX liab.) + (FX bought - FX sold)
fx risk exposure
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)
  • Greater exposure to a foreign currency combined with greater volatility of the foreign currency implies greater DEAR.
fx trading activities
FX Trading Activities
  • FX markets turnover often greater than $1 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.
trading activities
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.
profitability of foreign currency trading
Profitability of Foreign Currency Trading
  • For large US banks, trading income is a major source of income. It is also very volatile.
  • In first two activities, bank acts primarily as an agent.
  • FI does not assume FX risk in first two activities.
profitability of foreign currency trading continued
Profitability of Foreign Currency Trading (continued)
  • Risk arises from taking open positions in currencies.
  • Effects of Euro on FX volatilities.
  • Emerging markets effects.
    • Increased volatility in some currencies.
  • Recent calls for additional regulation.
risk and hedging
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.
no arbitrage condition
No Arbitrage Condition:
  • 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.
  • Interest rate parity theorem.
diversification effects
Diversification Effects
  • Since the banks generally take positions in more than one currency simultaneously, their risk is partially reduced through diversification.
  • Overall, world bond markets are partially but not fully integrated which leaves open the opportunity to reduce exposure by diversifying.
diversification effects continued
Diversification Effects (continued)
  • Low correlations between the bond returns may be due to low correlation of real interest rates over time and/or inflation expectations.