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Introduction to Foreign Exchange Risk


  • Sources of FE Risk:
  • Large financial institutions hold significant foreign currency assets and liabilities and also buy/sell significant amount of foreign currency.
  • An institution’s actual exposure to any given currency is its net exposure to the currency.
    • For example, a bank’s net Great Britain Pound(GBP) exposure is given by:
    • net GBP exposure = (GBP assets – GBP liabilities) + (GBP bought – GBP sold)
    • i.e., net GBP exposure = net GBP assets – net GBP bought
  • A positive net exposure (net long) is subject to the risk that the foreign currency will fall while a Negative net exposure (net short) is subject to the risk that the foreign currency will rise.
  • Thus if the institution fails to maintain a position where net assets matches net liabilities in the foreign currency, it’s exposed to the risks due to fluctuations in that currency

Sources of profits and losses on foreign exchange trading

  • A financial institution derives profits from differences between income and costs of funds.
  • In foreign exchange markets, an extra dimension “foreign exchange rate” comes into play increasing the volatility of net returns of the bank if unhedged 
  • In foreign exchange markets, hedging is of two types:
    • Balance sheet hedging
    • Off balance sheet hedging
  • Balance sheet hedging is achieved when the financial institution matches maturity and currency in the foreign asset-liability book
  • Off balance sheet hedging is done by taking a position in the forward market

Example: Unhedged foreign asset and liabilities

  • Consider the balance sheet of a US bank:

Assets

Liabilities

USD 10 million 7% US loans, maturity 1 year

USD 10 million equivalent 12% Euro loans,
1-year maturity

USD 20 million 5% CDs maturity 1 year

  • What is the return for the bank if:
    • Exchange rate is unchanged
    • If exchange rate of euro has fallen from 1.2 dollars/euro to 1.05 dollars/euro
    • If exchange rate of euro has risen from 1.2 dollars/euro to 1.35 dollars/euro

Solution

  1. Average return on assets = (10(7)+10(12) )/2 = 9.5%.
  • Cost of funds = 5%
  • Therefore, net return = 4.5%
  1. Issued euro loans= 10,000,000/1.2= 8333,333 euros; 
  • End of maturity at 12% interest,  8,333,333*1.12=9,333,333
  • Dollar value=9,333,333*1.05=9,800,000.. i.e 2% loss
  • Average return = (-2+7)/2= 2.5%
  • Cost of funds = 5 %
  • Net return= -2.5% (loss)
  1. Euros received at the end of maturity = 9,333,333*1.35 = 12,560,000 i.e. 25.6%
  • Average return = (25.6+7)/2 = 16.3%
  • Cost of funds = 5%
  • Net return = 11.3%

Balance sheet hedging

  • In the previous example, matching the maturity duration but not the currency composition made the returns very unpredictable. One way to minimize this risk is through balance sheet hedging. Consider the modified balance sheet of the previous example after hedging.

Assets

Liabilities

USD 10 million 7% US loans, maturity 1 year

USD 10 million equivalent 12% Euro loans,
1-year maturity

USD 10 million 5% CDs, 1 year maturity
USD 10 million 9% euro CDs, 1 year maturity

 

Balance sheet hedging

  • Now even if the euro falls from 1.2 USD/euro to 1.05 USD/euro, the bank can lock in a
  • positive return
  • Steps:
    1. The bank borrows USD 10 million equivalent of Euros for a year at 9%. i.e., 10/1.2 = 8,333,333 Euros
    2. Pays back the Euro CD holders at the end of maturity i.e., 8,333,333*1.09=9,083,332 Euros. Euro depreciated to 1.05 USD i.e., 9083,332*1.05 = 9,537,499 dollars. i.e., cost of funds = -4.6%
    3. As calculated in previous problem, it receives an USD equivalent of 9,800,000 from the 12% euro loans granted. i.e., -2%
    • Average return on assets = (-2+7)/2 = 2.5%
    • Average cost of funds = (-4.6+5)/2 = 0.2%
    • Net return = 2.3%

Interest rate parity

  • In the previous examples, the Euro loans have better return than US loans and lead to arbitrage argument
  • As more banks move to euro loans, the spot exchange rate for buying euro will rise because of excess demand of Euro
  • In equilibrium, the forward exchange rate falls to completely eliminate the attractiveness of Euro investments. This is called Interest Rate Parity (IRP)


 

  • Where; rDC = Domestic currency rate

                   rFC = Foreign currency rate

 

Example

A japanese investor can invest in Japanese Yen at 4.5% or in GBP at 4.67%. Current spot rate is     0.01 JY/pound. Calculate 1 year forward rate in JY/GBP
 

Solution

Forward = spot * (1+Rdc)/(1+Rfc) = .01 * (1.045/1.0467) = 0.00998 Japanese yen per pound

 





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