Chapter 13: Foreign Exchange Risk Flashcards
What are the four FX risks faced by FIs?
(1) trading in foreign securities,
(2) making foreign currency loans,
(3) issuing foreign currency-denominated debt, and
(4) buying foreign currency-issued securities.
What is the spot market for FX? What is the forward market for FX? What is the position of being net long in a currency?
The spot market for foreign exchange involves transactions for immediate delivery of a currency,
While the forward market involves agreements to deliver a currency at a later time for a price or exchange rate that is determined at the time the agreement is reached.
The net exposure of a foreign currency is the net foreign asset position plus the net foreign currency position. Net long in a currency means that the amount of foreign assets exceeds the amount of foreign liabilities.
What two factors directly affect the profitability of an FI’s position in a foreign currency?
the size of the net exposure, and
the volatility of the foreign exchange ratio or relationship.
What are the four FX trading activities undertaken by FIs? How do FIs profit from these activities?
The four areas of FX activity undertaken by FIs are either for their customer’s accounts or for their own proprietary trading accounts. They involve the purchase and sale of FX in order to (a) complete international commercial transactions, (b) invest abroad in direct or portfolio investments, (c) hedge outstanding currency exposures, and (d) speculate against movements in currencies.
Most banks earn commissions on transactions made on behalf of their customers. If the banks are market makers in currencies, they make their profits on the bid-ask spread.
What motivates FIs to hedge foreign currency exposures?
FIs hedge to manage their exposure to currency risks, not to eliminate it. As in the case of interest rate risk exposure, it is not necessarily an optimal strategy to completely hedge away all currency risk exposure. By its very definition, hedging reduces the FI’s risk by reducing the volatility of possible future returns.
What are the limitations to hedging foreign currency exposures?
This narrowing of the probability distribution of returns reduces possible losses, but also reduces possible gains.
What are the two primary methods of hedging FX risk for an FI?
The manager of an FI can hedge using on-balance sheet techniques or off-balance sheet techniques. On-balance sheet hedging requires matching currency positions and durations of assets and liabilities. If the duration of foreign-currency-denominated fixed-rate assets is greater than similar currency denominated fixed-rate liabilities, the market value of the assets could decline more than the liabilities when market rates rise and therefore the hedge will not be perfect. Thus, in matching foreign currency assets and liabilities, not only do they have to be of the same currency but also of the same duration in order to have a perfect hedge.
How does the lack of perfect correlation of economic returns between international financial markets affect the risk-return opportunities for FIs holding multicurrency assets and liabilities?
If financial markets are not perfectly correlated, they provide opportunities to diversify and reduce risk from mismatches in assets and liabilities in individual currencies. The benefits of diversification depend on the extent of the correlations. The lower the correlation, the greater the benefits.
What is the PPP theorem?
As relative inflation rates (and interest rates) change, foreign currency exchange rates that are not constrained by government regulation should also adjust to account for relative differences in the price levels (inflation rates) between the two countries. According to purchasing power parity (PPP), foreign currency exchange rates between two countries adjust to reflect changes in each country’s price levels (or inflation rates and implicitly interest rates) as consumers and importers switch their demands for goods from relatively high inflation (interest) rate countries to low inflation (interest) rate countries. Specifically, the PPP theorem states that the change in the exchange rate between two countries’ currencies is proportional to the difference in the inflation rates in the two countries.
Explain the concept of IRP.
Interest rate parity argues that the discounted spread between domestic and foreign interest rates is equal to the percentage spread between forward and spot exchange rates. If interest rate parity holds, then it is not possible for FIs to borrow and lend in different currencies to take advantage of the differences in interest rates between countries. This is because the spot and forward rates will adjust to ensure that no arbitrage can take place through cross-border investments. If a disparity exists, the sale and purchase of spot and forward currencies by arbitragers will ensure that in equilibrium interest rate parity is maintained.
What is the relationship between the real interest rate, the expected inflation rate, and the nominal interest rate on fixed-income securities in any particular country?
The nominal interest rate is equal to the real interest rate plus the expected inflation rate on assets where default risk is not an issue. The strength of correlations among countries whose economies are considered to be the leaders of the industrialized nations is evidence that the world capital markets among these markets are reasonably well-integrated.
What is economic integration? What impact does the extent of economic integration of international markets have on the investment opportunities for FIs?
If markets are not perfectly correlated, some barriers for free trade exist between the markets and, therefore, they are not fully integrated. When markets are fully integrated, opportunities for diversification are reduced. Also, real returns across countries are equal. Thus, diversification benefits occur only when nominal and real rates differ between countries. This happens when some formal or informal barriers exist to prevent the free flow of capital across countries.
