Foreign Exchange RiskChapter 15 Financial Institutions Management, 3/e By Anthony Saunders
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 • 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 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 • 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 • 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) • 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 • 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: • 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 • 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) • Low correlations between the bond returns may be due to low correlation of real interest rates over time and/or inflation expectations.