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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
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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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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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%
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