FIN 683 Financial Institutions Management Foreign-Currency Risk

Transcription

1 FIN 683 Financial Institutions Management Foreign-Currency Risk Professor Robert B.H. Hauswald Kogod School of Business, AU Global Banks 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 Follow the money: customers are global significant currency exposures 2

2 Foreign Exchange Transactions FX markets Spot foreign exchange transaction Forward foreign exchange transactions Foreign-currency denominated positions Net exposure i = (FX assets i - FX liab i ) + (FX bought i - FX sold i ) FI may be Net Short, or Net Long 3 Foreign Exchange Rate Quotes Price at which one currency can be exchanged for another: exchanging money for money ISO codes: GBP, CHF, SGD, JPK, RUB Direct quote: US dollars serves as underlying Example: CAD per USD Indirect quote: In the US, this means the price of the US dollar in terms of the foreign currency Example: USD per CAD The terms direct and indirect depend on where the quote is obtained: USD, EUR, GBP take role of good 4

3 Changes in FX Activities Increased value of foreign claims & positions global lending and investing e.g.: invest in high interest rate currencies financed with short positions in low interest rate currencies Decreased volume of currency trading less profitable, higher volatility in FX markets fewer currencies (EUR) that were consistently appreciating: led to increased hedging activity FX markets as an asset class 5 FX Exposure FI have typically positions in spot and forward markets; other derivatives as well Natural hedge: underlying principle? 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 6

4 Assessing FX Exposure Greater DEAR (what is it?) if greater exposure to a foreign currency combined with greater volatility of the foreign currency FX and IR correlations: portfolio effects are very important Dollar loss/gain in currency i = [Net exposure in foreign currency i measured in U.S. $] Shock (Volatility) to the USD/S i FX rate Example: October 1998, more than a seven percent one-day drop in value of the dollar against the yen what happened, financial news of the day? 7 FX Trading FX markets turn over as high as $4 trillion per day The market moves between financial centers rotating book: integrated trading, risk and FX management essentially a 24-hour market: continuous trading Growth in electronic FX trading automated execution Overnight exposure adds to the risk ultra short-term prop (or day?) trading: the 10-minute bet FIs need dependable measures of FX exposure worthless in isolation, priceless in integration 8

5 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 such an ugly word: enhancing shareholder returns through selective risk taking Substantial risk arises via open positions you better be able to sleep well with them 9 Trading Volume by Location Source: BIS Triennial Survey 2007 One can see why London is considered to be the world's capital of Forex trading. It has the largest turnover since it is home to many large banks and funds that are prominent players in the world of currencies. 10

6 Overlap of Trading Zones 11 The Average Range 12

7 Profitability of FX Trading For large US banks, trading income is a major, but declining source of income market making, or acting as agents of customers, is only a secondary revenue source Citigroup and J.P. Morgan Chase dominant in FX trading in US: can anybody guess why? risk from taking open positions in currencies: how do they deal with them? Large corporations increasingly compete with banks in the FX markets same trend as in money markets (CP, etc.) 13 Currency Distribution: Daily Volume Source: BIS Triennial Survey

8 Foreign Assets & Liabilities Mismatches between foreign asset and liability portfolios Ability to raise funds internationally diverse opportunities as well as risks Exploit market imperfections in foreign banking markets: swaps regulatory, informational frictions: clientele effects And, there is greater FI competition in welldeveloped (lower risk) markets 15 Risk and Return of Foreign Investments Returns are affected by: spread between costs and revenues changes in FX rates can dramatically alter returns to foreign investments problems assessing counterparty risk Changes in FX rates are not under the control of the FI but then, what is? similarities with exposure to interest rate risk indeed, every FX exposure is an IR exposure 16

9 FX Exposure Hedging Hedge can be on or off balance sheet no match, no hedge principle: A&L again what is a hedge to me, might be On-balance-sheet hedge also require duration matching to control exposure to foreign interest rate risk Off-balance-sheet hedge using derivatives: forwards, futures, or options sell the proceeds of a British pound loan forward, eliminating future spot FX risk assuming borrower does not default & forward buyer does not renege: reverse 17 Multicurrency Positions Since the banks generally take positions in more than one currency simultaneously, their risk is partially reduced through diversification what other risk do you need to take into account? World bond markets are not fully integrated leaves open the opportunity to reduce exposure by diversifying No risk, no return? 18

10 Diversification Effects High correlations between the bond returns 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] this expression is only an approximation Reflection of what? What determines real interest rates? 19 Purchasing Power Parity In equilibrium, real rates of interest should be equal across countries so that differences in nominal interest rates reflects differences in inflation rates across countries long-run equilibrium: economic statement Exchange rates should adjust in response to differences in inflation rates: Big Mac Index i Domestic i Foreign = S Domestic/Foreign / S Domestic/Foreign 20

11 Interest Rate Parity Theorem Equilibrium condition between money and FX markets: no arbitrage (NFL) condition there should be no arbitrage opportunities available through lending and borrowing across currencies, which requires 1+ r ust = (F t /S t ) [1+r foreign t ] The difference in interest rates will be offset by the expected change in exchange rates Covered vs Uncovered Interest Parity why not leave the forward leg open? 21 Summary FX exposure: counterparty to operations trading less important: specialist competition foreign-currency denominated A&L: on the rise, simply a sign of FX risk integrated with IR risk common trading: common risk management DEAR: works well Hedging: mainly through derivatives 22

12 Fisher Equation Precise statement of approximation above the actual Fisher equation includes one additional term: cross product of inflation and the real interest rate. r i = rr i + i e i + (rr i i e i ) Crossterm matters if inflation or real rate is large hyperinflations in Brazil and other countries where the inflation rate exceeded 100% or as experienced in Zimbabwe, more than 4,500% 23 Pertinent Websites Federal Reserve Bank Citigroup J.P. Morgan Chase U.S. Treasury BIS 24