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Lecture 5

Foreign Exchange Risk


Financial crises related to sovereign debts and
exchange rates
• Latin American debt crisis (1980s)
– http://en.wikipedia.org/wiki/Latin_American_debt_crisis
• Black Wednesday for British Pound: 1992
– http://en.wikipedia.org/wiki/Black_Wednesday
• Mexican peso crisis: 1994
– http://en.wikipedia.org/wiki/1994_economic_crisis_in_Mexico
• Asian Financial Crisis (1997)
– http://en.wikipedia.org/wiki/1997_Asian_Financial_Crisis
• Ruble Crisis (1998)
– http://en.wikipedia.org/wiki/1998_Russian_financial_crisis

Introduction 2
Foreign Currency Exposure in Australia

http://www.rba.gov.au/publications/bulletin/2017/dec/8.html
Introduction 3
Historical AUD exchange rates
AUD Exchange Rate
140.0 1.6000

1.4000
120.0

1.2000
100.0

1.0000
80.0

0.8000

60.0
0.6000

40.0
0.4000

20.0
0.2000

0.0 0.0000

AUD trade-weighted index (left scale) AUD/USD (right scale)

Data source: RBA


https://www.rba.gov.au/statistics/historical-data.html#exchange-rates

Introduction 4
Overview of lecture topics
• This lecture discusses
– the measurement of foreign exchange risk to which FIs are
exposed
– the management of foreign exchange risk
– the theories of the exchange rates.

Introduction 5
Volatility of Foreign Exchange Rate
• Foreign Exchange Rate Quotes
– Direct quote: the price of the foreign currency expressed in the local
currency, example: AU$0.95 per US$
– Indirect quote: the price of the local currency in terms of the foreign
currency, example: US$1.05 per AU$
– If not explicitly specified, we will be using the direct quotes by default.
– Textbook and tutorial questions: using U.S. as the home country and
USD as the home country currency since the textbook is written by U.S.
authors, but in lecture notes and exam we will use Australia as the home
country and AUD as the home country currency

• Reason for FX volatility: fluctuations in the demand for and supply of a


country’s currency.
– We will discuss two theories of foreign exchange rate determination later.

• Exchange rate: (from RBA)


– http://www.rba.gov.au/statistics/frequency/exchange-rates.html

Introduction 6
Sources of Foreign Exchange Risk Exposure
• Foreign exchange risk
– Potential loss in foreign currency positions and/or net
investments denominated in foreign currencies due to
the movement of foreign exchange rates (i.e., the
movement in prices of foreign currency).

FX risk exposure 7
FX exposure

• Net exposure of an FI in a foreign currency i:


= (FX assetsi – FX liabilitiesi) + (FX boughti – FX soldi)
= Net foreign assetsi + Net FX boughti
Where:
i = ith currency
Net long in a currency: Net exposure > 0
Net short in a currency: Net exposure < 0

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FX risk exposure
FX exposure
• A positive net exposure implies that a FI is overall net
long in a foreign currency.
– The FI faces the risk that the foreign currency will depreciate
against the domestic currency.

• A negative net exposure implies that a FI is overall net


short in a foreign currency.
– The FI faces the risk that the foreign currency will appreciate
against the domestic currency.

• Failure to maintain a fully balanced position in any given


foreign currency exposes a FI to the fluctuations in the
FX rate of that currency against the domestic currency.

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FX risk exposure
FX exposure through foreign currency trading

• FIs are involved in FX trading mainly through the


following four activities. FIs purchase and sale of foreign
currencies to:
– Allow customers to participate in international commercial trade
transactions,
– Allow customers to take positions in foreign investments (real
and financial)
– Hedge exposures in any given currency,
– Speculate through the anticipation of future movements in FX
rates.
• In the first two activities, the FI normally acts as an agent
of its customers for a fee but does not assume the FX risk
itself.
• In the third activity, the FI acts defensively as a hedger to
reduce FX risk exposure.
FX exposure – FX trading 10
Foreign exchange market
(For your knowledge only)
• Major foreign exchange markets:
– Foreign exchange swaps
– Spot market for foreign exchange (FX): trading for immediate delivery.
– Forward market for foreign exchange (FX): trading for future delivery.
– Foreign exchange options
• Biggest financial market
– High trading volume and liquid
– geographical dispersion and continuous operation
• According to Triennial Central Bank Survey (December 2007, Bank for
International Settlements), as of April 2007,
– average daily turnover in global foreign exchange markets is estimated
at $3.98 trillion
– $3.21 Trillion is accounted for in the world's main financial markets
$1.714 trillion in foreign exchange swaps (53.4%)
$1.005 trillion in spot transactions (31.31%)
$362 billion in outright forwards (11.28%)

FX exposure – FX trading 11
Foreign Currency Trading: Australian Dollar
(For your knowledge only)
• According to BIS (Bank for International Settlements), as at April
2007, the daily foreign exchange turnover against Australian dollars
is US$133.33 billion (US$3.98 trillion*6.7%/2).
• As at March 2010, according to RBA,
(http://www.rba.gov.au/statistics/tables/index.html#exchange_rat
es)
Turnover in millions of Composition
Currency
of instruments
AUD OTC options
swaps
6%
140000 2%

120000
100000
Outright spot
80000 24%
60000 Outright
forward
40000 4%
20000 FX swaps
64%
0

FX exposure – FX trading 12
Foreign assets and liabilities positions

• FIs often hold foreign assets and liabilities.


• FIs acquire foreign assets and liabilities not only to
diversify their sources and uses of funds but also to
exploit imperfections in foreign banking markets that
create opportunities for higher returns on assets or lower
funding costs.
• For example
– Australian banks can buy Mexican peso denominated sovereign
bonds which pay 6.5% interest (foreign assets).
– Australian banks can also issue U.S. dollar denominated bonds
to raise cheaper funds from the U.S. (foreign liabilities)

FX exposure – FX asssets/liabilities 13
FX risk exposure through
foreign assets and liabilities positions
• Risk arises from mismatches between FI’s foreign
financial assets and foreign financial liabilities.

The Return and Risk of Foreign Investments:


• Returns are affected by:
– Difference between income and cost, i.e., return in terms of
foreign currency
– Fluctuations in FX rates.
• RDC = (1 + RFC) * (S1 / S0) – 1
– Where RDC and RFC are investment returns denoted in domestic
and foreign currencies respectively, and S0 and S1 are spot
exchange rates (direct quote) as of the beginning and ending of
investment period respectively.

FX exposure – FX asssets/liabilities 14
Example
• Suppose an AU FI has the following assets and liabilities
Assets Liabilities
$100 million AUD loans (1- $200 million CDs (1 year)
year) (9% interest rate) in AUD, (8% interest rate).

$100 million equivalent


U.K. loans (1 year) made in
pounds (15% interest rate)

• Exchange rate
– Spot rate at the beginning of the year $1.60/£1.
– Spot rate at the end of the year $1.45/£1.
• What is the FI’s return on the investments?

FX exposure – FX asssets/liabilities 15
Example
• End-of-year dollar amount from UK loan
– Sell $100 million for pounds at the spot exchange rate $1.60/£1.
This translates into $100/1.6=£62.5 𝑚𝑖𝑙𝑙𝑖𝑜𝑛.
– Make a one-year U.K. loan at 15% interest rate, and end of year
pound revenue is £62.5*1.15=£71.875.
– Sell the £71.875 at the spot exchange rate $1.45/£1,
£71.875*1.45=$104.22 𝑚𝑖𝑙𝑙𝑖𝑜𝑛.

• 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑡ℎ𝑒 𝑙𝑜𝑎𝑛=($104.22−$100)/$100=4.22%.


– Alternative calculation: (1+15%)*1.45/1.60 – 1 = 4.22%
– This return is lower than the 8% the FI pays on the CD and thus
the U.K. loans incur a loss for the FI.
– And the return depends on the exchange rate at the end of year!

FX exposure – FX asssets/liabilities 16
Hedging FX Risk
On-Balance-Sheet Hedging:
• Match the size of assets and liabilities denominated in foreign currencies
• Requires duration matching to control exposure to foreign interest rate risk.

Relationship between interest rate and fx rate:


http://www.investopedia.com/ask/answers/040315/how-do-changes-national-
interest-rates-affect-currencys-value-and-exchange-rate.asp

Off-Balance-Sheet Hedging:
• Uses forwards, futures, or options.
• Example: hedging US$100 million foreign asset position with 1-year maturity by
taking a short position in the forward market – selling US$ for AU$ in 1 year.

Hedging via Multicurrency Foreign Asset–Liability Positions


• Hedging does not necessarily require an FI to hedge positions in individual
foreign currencies one by one.
• Banks generally have positions in multiple currencies, and the foreign exchange
returns of these currencies are normally not perfectly correlated
– Risk reduction through diversification,
– Reduction of cost of funds.

Hedging 17
Example
• On-balance-sheet hedging
Assets Liabilities
$100 million AUD loans (1- $100 million CDs (1 year) in
year) (9% interest rate) AUD, (8% interest rate).
$100 million equivalent $100 million equivalent
U.K. loans (1 year) made in U.K. CDs (1 year) in pounds
pounds (15% interest rate) (11%)

• Because the $100 million equivalent U.K. loans are


matched with $100 million equivalent of U.K. CDs, the
bank lock in a positive interest spread of 15%-11%=4%.
• This locks in a net interest income on U.K. loans of
£62.50.04=£2.5 𝑚𝑖𝑙𝑙𝑖𝑜𝑛.
– The net interest income in UK loans is still exposed to FX risk.

Hedging 18
Example
• Off-balance-sheet hedging with forwards
– As a low cost alternative to on-balance-sheet hedging, the FI
could hedge by selling the expected one-year pound loan
proceeds in the forward FX market at today’s known forward
exchange rate, say, $1.55/£1.
– This removes the uncertainty regarding the future spot rate on
pounds at the end of the one-year investment horizon and thus
the uncertainty relating to the return on the British loan.

Assets Liabilities
$100 million AUD loans (1- $200 million CDs (1 year)
year) (9% interest rate) in AUD, (8% interest rate)
$100 million equivalent
U.K. loans (1 year) made in
pounds (15% interest rate)

Hedging 19
Example
• End-of-year dollar amount from UK loan, when hedging
with forwards
– Sell $100 million for pounds at the spot exchange rate $1.60/£1.
This translates into $100/1.6=£62.5 𝑚𝑖𝑙𝑙𝑖𝑜𝑛.
– Make a one-year U.K. loan at 15% interest rate, and end of year
pound revenue is £62.5*1.15=£71.875.
– Sell the £71.875 at the pre-agreed forward rate $1.55/£1,
£71.875*1.55=$111.41 𝑚𝑖𝑙𝑙𝑖𝑜𝑛.

• 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑡ℎ𝑒 𝑙𝑜𝑎𝑛=($111.41−$100)/$100=11.41%.


– Alternative calculation: (1+15%)*1.55/1.60 – 1 = 11.41%
– And the return is fixed and locked in today!

Hedging 20
Theories on foreign exchange rate
• Purchasing power parity theorem

• Interest rate parity theorem

FX pricing 21
Purchasing Power Parity (PPP)
• The exchange rate should be determined based on the
purchasing power of currencies.
– The concept is founded on the law of one price, that is, in
absence of transaction costs, identical goods will have the same
price in different markets.
• Absolute PPP Theory: A theory on the level of exchange
rates
– Domestic and foreign currencies should have the same
purchasing power after adjusting for exchange rate – i.e., being
able to purchase the same amount of goods and services
– 1 $F / Price$F = S$D / Price$D
– Hence, Exchange Rate ($D/$F) = S = Price$D / Price$F
– Example, The Economist’s Big Mac Index
(http://www.economist.com/content/big-mac-index)
– Assumption of perfect arbitrage for goods and services, which is
problematic
FX pricing 22
Purchasing Power Parity (PPP)
• Relative PPP Theory: A theory on the movement in
exchange rates
– PPP theory may not hold for the level of exchange rate, but may
hold for the change.
– The change in exchange rate should reflect the change in the
relative purchasing powers of currencies, which is the difference
in inflation rates

ΔS/S = (ΔPrice$D/Price$D) - (ΔPrice$F/Price$F)


ΔS/S = iD – iF
where i refers to inflation rate, and S is the exchange rate of foreign
currency in direct quote format.

• In this lecture, PPP refers to the relative version of PPP.


FX pricing 23
Purchasing Power Parity (PPP), Cont’d
• Nominal and real interest rate
• 𝑟 = 𝑖+rr where
– 𝑟 = (nominal) 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒
– rr = 𝑟𝑒𝑎𝑙 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡
– 𝑖 = expected 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒.

• In equilibrium, real rates of interest should be equal across


countries due to arbitrage, and therefore, differences in
nominal interest rates reflects differences in inflation rates
across countries
rD – rF = (rrD+iD) - (rrF+iF) = iD – iF = ΔS / S

– Thus a higher interest rate implies a higher expected inflation rate,


and the local currency is expected to depreciate
– However, this is based on the assumption that the real interest rate
equals across countries, which relies on the perfect capital mobility
and no-arbitrage and may not be the case.
FX pricing 24
Interest Rate Parity Theorem (IRPT)
• The IRPT assumes no arbitrage in FX market – the
following two investment strategies should produce the
same returns
– Investing in domestic government securities, where the return is
guaranteed as (1+rD)
– Investing in foreign government securities which guarantees a
return of (1+rF) in foreign currency , and fixing the return in
domestic currency at the end of investment period by selling
foreign currency at 1-year forward exchange rate (F). By doing so,
the return is also guaranteed as (1/ S0)*(1+rF)*F.

FX pricing 25
Interest Rate Parity Theorem (IRPT)
• Hence IRPT states that the spread between domestic and
foreign interest rates equals the percentage spread
between forward and spot exchange rates.
▪ (1+rD) = (1/ S0)*(1+rF)*F => 1+rD = (1+rF)*F / S0
▪ (1+rD)/ (1+rF) = F/ S0 => (rD-rF)/ (1+rF) = (F- S0)/ S0
▪ Where S0 and F are spot and forward exchange rate in direct quote.
▪ Since F is determined based on market expectation of future
exchange rate, a relatively higher domestic interest rate indicates
that domestic currency is expected to depreciate in the future.

FX pricing 26
Interest Rate Parity Theorem: Application
• Assume the interest rate on Australian dollar securities
at time t (rD,t) equals 5% and the interest rate on Euro
loans at time t (rF,t) = 10%. Supposing the $/€ spot
exchange rate (St) at time t is $0.60/€1, what should be
the 1-year forward exchange rate (Ft) based on IRPT?

• (rD-rF)/(1+rF) = (F- S0)/ S0


▪ So F is $0.57/€1 according IRPT.

FX pricing 27
Interest Rate Parity Theorem: Application
• If the forward exchange rate is 0.59 instead, is the
domestic currency under-valued, over-valued, or fairly
valued in the spot currency market relative to the
forward exchange rate?
– Based on the current spot rate, the forward rate should be 0.57
which is lower than the actual forward rate 0.59.
– So € is overpriced with respect to $ in the forward market
(relative to the spot market).
– It also means that € is undervalued in the spot market (relative
to the forward market)
– thus $ is relatively overvalued in the spot market.
– To verify this: (rD-rF)/(1+rF) = (F- S0)/ S0
– So based on F = 0.59, S0 should be 0.62 > current spot rate (0.6).
So € is relatively undervalued in the spot market, which means $
is relatively overvalued.

FX pricing 28
Interest Rate Parity Theorem: Application
• How to design arbitrage trading strategy based on the information above?
– Since the actual forward rate is higher than the IRPT-implied forward
rate, the arbitrage trading strategy should involve selling € at the
forward rate (short € in the forward market).
– To cover your obligation to deliver € under the short forward contract,
you have to buy € in the spot market.
– So a complete trading strategy is:
1) sell one € at the forward rate 0.59, which costs you nothing now,
but you are expected to deliver one € and receive 0.59 $ in one
year
2) buy 1/(1+10%) = 1/1.1 € in the spot market and invest the amount
in the foreign market at 10% for one year, which costs you
(1/1.1*0.6) $ now, and yields 1 € in one year
3) borrow 0.59/(1+5%) = (0.59/1.05)$ now in the domestic market
at 5% interest rate for one year, which gives you (0.59/1.05)$
now, but you are expected to pay 0.59$ in one year
4) Cash flows: a) at time 0, (0.59/1.05) - (1/1.1*0.6) = $ 0.01645; b)
at time 1, 0.

FX pricing 29
Uncovered Interest Rate Parity Theorem
• Recall the trading strategy to derive IRPT
– Invest in domestic government securities, where the return is guaranteed
as (1+rD)
– Invest in foreign government securities and guarantee a domestic
currency return of (1/ S0)*(1+rF)*F with short forward contract.
– The derived IRPT theory: (rD-rF)/(1+rF) = (F- S0)/ S0 , is called as Covered
IRPT theorem, because both legs produce certain returns.

FX pricing 30
Uncovered Interest Rate Parity Theorem
• If you don’t hedge the foreign exchange risk in the foreign market investment:
• the return is (1/ S0)*(1+rF)*S1. where S1 is the spot exchange rate in one
year and uncertain.
• Since domestic investment return is certain and foreign one is not, the
returns of two investment strategies are not necessarily equal (subject to
exchange rate movement).
• But on average, they should be roughly equal: (1+rD) ~= (1/ S0)*(1+rF)* S1
• Hence we can derive a slightly different version of IRPT
(rD-rF)/(1+rF) ~= (S1 - S0)/ S0
• The same implication holds here: a relatively higher domestic interest rate
indicates that domestic currency is expected to depreciate in the future.
• This version of IRPT is called as Uncovered IRPT.
• In this lecture, IRPT refers to the Covered version.

FX pricing 31