Foreign Exchange Risk Management

Transcription

1 Foreign Exchange Risk Management Perry D. Mehta Federal Reserve Bank of Richmond, Charlotte Office Seminar for Senior Bank Supervisors from Emerging Economies Washington, DC October, 2002

2 Outline Features of the spot fx market What determines exchange rates Key risks to banks from their fx positions Measuring and managing fx risk At all stages, we will consider Supervisory Issues, with review at end 2

3 Features of FX Markets Cash market turnover $1.5 trillion/day About 5 X combined $ volume of NYSE, AMEX, NASDAQ, U.S. bond market Average transaction size up from $0.75 million in 80s to $10 million Most liquid of all cash markets Very high trading frequency Very large transaction sizes do not affect price Continuous trading around the globe Dominated by USD 80% of transactions; 67% of size. 3

4 Major Players Dealers Commercial banks, investment banks Brokers Commercial banks, investment banks Other financial services firms Investment funds, insurance firms Non-financial corporations Governments and Central Banks Supranationals 4

5 Investment Objectives Hedge Speculate Arbitrage Meet customer needs Nonfinancial corporations Commercial banks Investment banks Investment funds; insurance cos. Supranationals Commercial banks Investment banks Commercial banks Investment banks Commercial banks Investment banks 5

6 Terminology Transaction to exchange amount of one currency for another Typically, an exchange of appropriate amounts of banks deposits The terms or price of the exchange = exchange rate If 1 USD buys 0.68 GBP, then exchange rate is 0.68 GBP/USD or 1.47 USD/GBP If bank pays 1 USD for 0.68 GBP, it is long 0.68 GBP, and short 1 USD. 6

7 Transaction Types Derivatives Cash / Spot Settled T+2 (T+1 for USD-CAD) Forward OTC settled in more than two days Swaps: FX versus Currency Exotic options Futures Cash options Futures options OTC Exchange traded 7

8 Spot Transaction AmeriBank buys 10 million worth of from CanaBank (= million) Ameribank is long mm, short 10 mm; CanaBank has mirror-image positions Ameribank will give irrevocable payment order to its clearing agent to credit CanaBank s account 10 mm CanaBank will give irrevocable payment order to its clearing agent to credit AmericBank s account mm Accounts are credited up to two days later 8

9 Settlement Exposure: AmeriBank 200 mm T T+1 T+2 T+3 Time (days) Status: Sell for R I U S or F Irrevocable payment order Pay Receive Confirm receipt R = Revocable I = Irrevocable U = Uncertain S = Settled F = Failed 9

10 Settlement Risk Risk that one party to a foreign exchange transaction will pay the currency it sold but not receive the currency it bought Due to Time zone differences in settlement systems Time period for settlement process Bankhaus Herstatt,

11 Determinants of Exchange Rate Relative economic conditions Trade, balance of payments Political risks Capital controls, trade barriers, expropriation Purchasing Power Parity Static (spot rate) Dynamic (forward/ expected future spot) Interest Rate Parity Covered (forward rate) Uncovered (expected future spot rate) 11

12 Purchasing Power Parity Static: Exchange rate = 0.68 /$ = 1.47 $/ Law of One Price = single good PPP = consumption basket Dynamic: $1.00 A loaf of 0.68 bread Rate of appreciation of against $ is the difference between inflation rates in the two countries PPP applies to tradable goods only. 12

13 Purchasing Power Disparities Government Trade barriers Capital controls Exchange controls Other regulations - tax Industry Product quality perceptions Supply reliability perceptions Infrastructure deficiencies 13

14 Interest Rate Parity Spot rate = /$ or $/ 3-mo 5%, 4% Spot rate in 3 mos? 3-mo forward rate today? Two investment alternatives: $1 Over 3 mos 1*(1+0.05/4) = $ $1 $??? Today 0.68 Over 3 mos 0.68*(1+0.04/4) = After 3 mos In 3 mos, = $1.0125, or e = /$ = $/ 14

15 Interest Rate Parity (2) Uncovered IRP Future movements of spot rate depend upon interest rates in the two currencies Covered IRP The forward rate today depends upon interest rates in the two currencies 15

16 Forward Hedge American importer must pay British firm 10mm in 3 months. Can purchase spot in 3 months Unknown e Can purchase forward. Advantages - No up-front $ payment Known exchange rate $ / In 3 months, pay $ mm to fx dealer, and receive 10 mm to pay British supplier. 16

17 Swaps FX Swap Two currency exchanges: first at value date, and then opposite exchange at maturity date Currency Swap Stream of currency exchanges: each payment based on the interest rate of that currency Similar to interest rate swap 17

18 Other Derivatives Futures Exchange-traded version of forwards Cash Options Exchange-traded, usually European-style Futures Options Exchange-traded, usually American-style Exotics: barrier, quanto 18

19 Futures Exchange-traded version of forward Standardized contract specifications Exchange is counterparty to both sides No counterparty credit risk Daily mark-to-market settlement 19

20 Futures Daily Settlement GBP December futures contract Size = 62,500 Initial margin $7,000; maintenance $5,600 Long Position Date Quote $/ Contract Cash Margin Margin Margin Value inflow Call Bal Balance 26-Oct $90,838 -$7,000 $0 $7,000 $7, Oct $91,381 $544 $0 $7,544 $7, Oct $90,013 -$1,369 $0 $6,175 $6, Oct $89,119 -$894 $1,719 $7,000 $5,281 1-Nov $90,219 $1,100 $0 $6,381 $6,381 2-Nov $91,050 $831 $0 $7,213 $7,213 20

21 Option Call option Right, but not obligation, to purchase a fixed quantity of the foreign currency, at a fixed price, at or before maturity. Put option sell a fixed quantity of foreign currency Example Call option on British pound, prices in US dollars 21

22 Call Option U.S. interest rate, r = 6% U.K. interest rate, r f = 5% Current exchange rate, S = 0.68 $/ Volatility in value of, σ = 15% Option expires in 3 months; T = 0.25 Strike price, X = 0.70 $/ 22

23 Call Option Value (T = 3 months) 0.25 Option Value in $ Underlying in $ Call Instrinsic 23

24 Call Delta, Gamma (T = 3 months) Gamma Delta Underlying in $ Gamma Delta (right scale) 24

25 Low T (1-day) Call 0.25 Option Value in $ Underlying in $ Call Instrinsic 25

26 Call Delta, Gamma (T = 1 day) Gamma Delta Underlying in $ Gamma (1-day) Delta (1-day) Gamma (3-mth) Delta (3-mth) 26

27 Risks In FX Transactions Price (market) risk Interest rate movements Credit risk Counterparty default Political risk Capital controls Expropriation Operational Risk IT systems Economic Activity Inflation rates Settlement: Payments system Trade barriers Tax, regulatory changes Internal Controls 27

28 Supervisory Review: Price Risk Position limits Transaction (spot, forward) Counterparty Currency Region VaR monitoring VaR limits by currency, region, product line Risk factor monitoring Greek limits: delta, gamma, vega More recently: vol term structure, vol skew 28

29 Supervisory Review: Credit Risk Counterparty Position limits Collateral Settlement system Netting: Obligation vs. Close-out; Bilateral vs. Multilateral Upgrade correspondent bank services Latest possible cut-off time Earliest possible confirmation of receipt 29

30 Supervisory Review: Political Risk Country risk monitoring Stress testing for event risk Expropriation Tax changes Regulatory changes Capital controls 30

31 IT Systems Systems integration Supervisory Review: Operational Risk Data input and transmission integrity Mix of manual and automated processes Incorporation of off-line deals Internal controls Audit of reporting trail Independence of risk measurement and reporting function from trading function. 31

32 References Foreign Exchange Committee (FXC) (private sector group sponsored by Federal Reserve Bank of New York) Guidelines for Foreign Exchange Trading Activity, 2001 Foreign Exchange Transaction Processing: Execution to Settlement - Recommendations for Nondealer Participants, 1999 Committee on Payment and Settlement Systems of Bank for International Settlements Survey of Electronic Money Developments, November 2001 Core Principles for Systemically Important Payment Systems, January 2001 Current Topics in Payment and Settlement Systems, December