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
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 Foreign Exchange Transactions
• FX markets
– Spot foreign exchange transaction
– Forward foreign exchange transactions
• Foreign-currency denominated positions
Net exposurei = (FX assetsi - FX liabi) + (FX
boughti - FX soldi)
– FI may be Net Short, or Net Long

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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: CAD1.1146 per USD
• Indirect quote: In the US, this means the price of
the US dollar in terms of the foreign currency
– Example: USD0.8972 per CAD
• The terms direct and indirect depend on where the
quote is obtained: USD, EUR, GBP take role of good
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 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
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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
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 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/Si 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?
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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
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 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
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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.

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 Overlap of Trading Zones

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The Average Range

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 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.)
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Currency Distribution: Daily Volume

Source: BIS Triennial Survey 2007

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 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 well-
developed (lower risk) markets
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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
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 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
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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?
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 Diversification Effects
• High correlations between the bond returns
– due to high correlation of real interest rates
over time and/or inflation expectations
ri ≈ rri + iei
• Nominal return ≈ real return + E[inflation]
– this expression is only an approximation
• Reflection of what?
• What determines real interest rates?
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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
iDomestic – iForeign = ∆SDomestic/Foreign / SDomestic/Foreign
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 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+ rust = (Ft/St)×[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?

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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
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 Fisher Equation
• Precise statement of approximation above
– the actual Fisher equation includes one additional
term:
– cross product of inflation and the real interest rate.
ri = rri + iei + (rri × iei )
• 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%

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Pertinent Websites
Federal Reserve Bank www.federalreserve.gov
Citigroup www.citigroup.com
J.P. Morgan Chase www.jpmorganchase.com
U.S. Treasury www.ustreas.gov
BIS www.bis.org

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