Lecture 5

Credit Risk II & Foreign

Exchange Risk
Sherry Zhang
xueting.zhang@unsw.edu.au
Last Week … Measuring credit risk 2

 Measurement of the credit risk on individual loans or bonds is crucial if

an FI manager is to
▪ price a loan or value a bond correctly, and
▪ set appropriate limits on the amount of credit extended to any one borrower
or the loss exposure it accepts from any particular counterparty.

 Qualitative credit risk models

 Quantitative credit risk models
▪ Credit scoring models
▪ Term structure based methods
▪ RAROC models
▪ Mortality rate models
Overview of lecture topics
3

 In this lecture we identify the issues involved in managing loan portfolios.

▪ Simple methods for measuring the level of loan concentration.
▪ Modern portfolio theory and its application to loan portfolios.
▪ Other methods based on partial application of MPT.

 We also discuss
▪ the measurement of foreign exchange risk to which FIs are exposed
▪ the management of foreign exchange risk
▪ the theories of the exchange rates.
Credit Risk II - Loan Portfolio Risk
Loan portfolio risk 5

 Managing a portfolio of loans is different from managing individual loans

because of the opportunity to diversify credit risk across individual loans
in the portfolio.

 The risk-return of the overall loan portfolio, with some of the risk of
individual loans diversified, affects an FI’s overall credit risk exposure.

 Loan concentration risk exists if FIs have too many loans concentrated
with one firm, industry, or economic sector.
Measuring loan concentration risk 6

 Simple Models
− Migration Analysis
− Concentration Limit

 Modern Portfolio Theory (MPT) Models

▪ Moody’s analytics portfolio manager model
▪ Partial application of the MPT
▪ Loan Volume-Based Models
▪ Loan Loss Ratio-Based Model
Simple Models of Loan Concentration Risk
7
 Migration Analysis:
▪ Examining how credit risk changes over time for different loan sectors
through credit risk migration or transition matrices.
▪ Step 1: sorting loans into different groups based on credit risk (measured by external or
internal rating) levels
▪ Step 2: calculating the proportions of loans in each (beginning-of-year) group at various
credit risk levels at the end of year.
▪ Step 3: comparing the actual credit deterioration with the historical numbers. If the
credit risk of a sector deteriorates faster than historical experience, then curtail lending
to that sector or loan class.

▪ Problem: the information may be too late, because ratings agencies

usually downgrade issues only after the firm or industry has experienced a
downturn.
Migration Analysis - Example
8

Consider the following rating migration matrix.

a) Complete the rating migration matrix, and explain how you do this.

?
The probability in each row has to sum up to 1.
b) What is the probability for a firm with risk grade '2' to default over the next
period?
Migration Analysis - Example 9

Consider the following rating migration matrix.

a) Complete the rating migration matrix, and explain how you do this.

The probability in each row has to sum up to 1.

b) What is the probability for a firm with risk grade '2' to default over the next
period? 6%
c) Calculate the probability for a firm with risk grade ‘2' to default over the
next two periods.
Migration Analysis - Example 10

Consider the following rating migration matrix.

c) Calculate the probability for a firm with risk grade ‘2' to default over the next
two periods.
There are the following ways from ‘2’ to ‘D’:

p = 0.001+0.0486+0.0024+ 0.06 = 0.1120.

Simple Models of Loan Concentration Risk 11

 Concentration Limits:
▪ Setting limits on the maximum loan size to individual borrowers or sectors.
▪ Used to reduce exposures to certain industries or geographical areas.

 Concentration limits for Sector i:

𝑀𝑎𝑥𝑖𝑚𝑢𝑚 𝑙𝑜𝑠𝑠 𝑎𝑠 𝑎 𝑝𝑒𝑟𝑐𝑒𝑛𝑡 𝑜𝑓 𝑐𝑎𝑝𝑖𝑡𝑎𝑙

𝐶𝑜𝑛𝑐𝑒𝑛𝑡𝑟𝑎𝑡𝑖𝑜𝑛 𝑙𝑖𝑚𝑖𝑡𝑖 =
𝐿𝑜𝑠𝑠 𝑅𝑎𝑡𝑒𝑖

▪ Suppose a FI manager is unwilling to permit losses exceeding 10% of the FI’s

capital to a particular sector, and the loss rate is 40% on defaulted loans in the
sector
▪ Then the concentration limit will be: 10%/40% = 25%
Modern Portfolio Theory (MPT) 12

 Expected return (Rp) on a portfolio of assets:

𝑁

𝐸(𝑅𝑝 ) = ෍ 𝑋𝑖 𝐸(𝑅𝑖 )
𝑖=1
▪ 𝐸(𝑅𝑖 ) = the return of asset i in the portfolio
▪ X𝑖 = the proportion of the asset portfolio invested in 𝑖th asset.

 The variance of portfolio returns or risk of the portfolio:

𝜎𝑝2 = σ𝑁 2 2 𝑁 𝑁
𝑖=1 𝑋𝑖 𝜎𝑖 + σ𝑖=1 σ𝑗=1,𝑖≠𝑗 𝑋𝑖 𝑋𝑗 𝜌𝑖𝑗 𝜎𝑖 𝜎𝑗

▪ σi 2 = variance of returns on the ith asset

▪ ρij = correlation between returns on the 𝑖th and 𝑗th assets
▪ ρijσiσj = the covariance of returns between the i th and j th asset
 Modern Portfolio Theory – simple 13
example
 If 𝜌𝑖𝑗 is negative for two borrowers 𝑖 and 𝑗 – that is, when one borrower’s
loans do badly and the another’s do well – then combining loans to both
borrowers may reduce the FI’s overall credit risk exposure.
 Calculate the expected return and risk of the portfolio.

▪ 𝐸 𝑅𝑝 = 0.4 1.0% + 0.6 12% = 11.2%

▪ 𝜎𝑝 2 = 0.4 2 (0.0857)2 + 0.6 2 (0.0980)2 +2 0.4 0.6 −.84 0.0857 0.0980

▪ 𝜎𝑝 = 𝜎𝑝 2 = 0.0012462 = 0.0353 = 3.53%

▪ Note that 𝜎𝑝 is smaller than both 𝜎1 and 𝜎2 in this example.

Modern Portfolio Theory
14
 Investor preference: as high return as possible but at the same time
prefer as low risk as possible.

 How to optimally allocate funds to different assets, which gives her

the lowest risk, volatility here, for a targeted expected return?

 Putting the question into mathematical terms, she is solving the

following optimization problems:

Minimize
𝜎𝑝2 = σ𝑁 2 2 𝑁 𝑁
𝑖=1 𝑋𝑖 𝜎𝑖 + σ𝑖=1 σ𝑗=1,𝑖≠𝑗 𝑋𝑖 𝑋𝑗 𝜌𝑖𝑗 𝜎𝑖 𝜎𝑗
subject to the constraint of achieving target return,
σ𝑁 ∗
𝑖=1 𝑋𝑖 𝐸(𝑅𝑖 ) = 𝑅𝑝 .
Modern Portfolio Theory: Efficient Frontier 15

 Solving the portfolio optimization problem will result in a set of optimal

weights on individual risky assets for a given level of target return.
▪ This set of asset weights determine one portfolio allocation with the given
expected return and a volatility of portfolio returns
▪ Repeating this for all target expected return levels, you will have many sets of
portfolio weights with corresponding expected returns and volatilities of
portfolio
▪ Plotting the expected returns and volatilities of these optimal portfolios will
give you the efficient frontier (of all risky assets)
Modern Portfolio Theory: Efficient Frontier 16

 A is inefficient because B has the same expected return but a lower risk.
 B and C are on the efficient frontier because the expected return is
maximized for any given level of risk or equivalently, risk is minimized for
any given level of expected return on the efficient frontier.
Modern Portfolio Theory - Implications 17
 When further introducing a risk-free asset (which gives a certain return),
investors’ portfolio allocation could be separated into two steps
▪ The optimal fraction of wealth to invest in the risky assets
▪ Then the optimal risky portfolio to invest

 Conclusion 1: Optimal risky portfolio

▪ Market portfolio of risky assets is the optimal portfolio of risky assets for anyone
▪ It is the most diversified portfolio, diversifying away any idiosyncratic risk
 Conclusion 2: CAPM on Risk-return relationship for individual risky assets
▪ the risk of an individual asset is determined by its systematic risk as measured by
beta (how it co-moves with market)
▪ the idiosyncratic risk (not correlated with market movement) is irrelevant or not
compensated by higher expected returns
Ri = Rf + Betai * (Rm - Rf)
Betai = Covariance(Ri, Rm)/Variance(Rm)
Applying MPT to credit risk analysis of loan
18
portfolio

 Optimization of loan portfolios

▪ We can view a bank issuing loans as an investor
▪ The objective is to choose an optimal allocation (weights) for all possible loans
▪ maximize the return of the loan portfolio, while at the same time minimize the
risk (volatility of return) of the loan portfolio.

 Required inputs for optimization

▪ Expected return on a loan to borrower i (Ri)
▪ Risk of a loan to borrower i (σi)
▪ Correlation between returns of loans made to borrowers i and j (ρij)
Application of MPT - Continue 19

Portfolio theory is a highly attractive tool but some questions

remain as to its applicability for banks:
1) Banks hold significant amounts of non-traded or infrequently traded
loans and bonds so it is difficult to estimate 𝐸 𝑅𝑖 , 𝜎𝑖 𝑎𝑛𝑑 𝜌𝑖𝑗 .
2) The application of modern portfolio theory requires the FI to trade loans
in the portfolio rather than hold them to maturity.
3) Returns on loans and bonds are highly skewed with limited upside. This
type of risk is difficult to “diversify away”. It requires tens of thousands of
different loans and bonds to be held.
▪ For example, on an individual bond there might be a 99.75% chance of a 7%
return in a year, and a 0.25% chance of a -60% return in the year.
Moody’s Analytics Portfolio Manager 20
Model
 The Moody’s analytics portfolio manager model is an implementation of
the modern portfolio theory.

 Moody’s has developed a proprietary model to estimate the value of

infrequently traded loans and thus the return, risk and correlations
between loans in an FI’s loan portfolio.

 Once these variables are estimated, they are then incorporated into the
standard MPT equations to get an estimate of the risk and return of the
FI’s loan portfolio.
 Moody’s Analytics Portfolio Manager
Model 21

Expected return on a loan in excess of the funding cost to borrower i:

AIS, if the borrower does not default with a probability of (1-EDF)

Expected Excess
Return, E(Ri) =
AIS – LGD, if the client’s default with a probability of EDF

E(Ri) = AISi (1 - EDFi) + (AISi - LGDi) EDFi Note: recall the expected return
= AISi - LGDi* EDFi formula in the last week’s lecture.
What is the relation between the
where two returns?
1) AIS (All-in-spread), is calculated as contractually promised return (k) minus funding cost, k –
FC%.
2) LGD (Loss Given Default), is the loss if the client defaults, calculated as contractually promised
return (k) multiplying by the (1 – recovery rate λ)
3) EDF (Expected Default Frequency) is the probability of default, estimated using an option pricing
model, see Chapter 10 pg.385-390
4) EDFi * LGDi is the expected loss.
Moody’s Analytics Portfolio Manager
Model 22

 Alternatively, we can write the excess return in the form:

E(Ri) = AISi - LGDi* Di
where Di is an indicator variable for loan default, which is a binomially distributed
random variable

 Risk of a loan to borrower i (σi)

𝜎𝑖 = 𝜎𝐷𝑖 × 𝐿𝐺𝐷𝑖 = 𝐸𝐷𝐹𝑖 (1 − 𝐸𝐷𝐹𝑖 ) × 𝐿𝐺𝐷𝑖
▪ where σDi is the volatility of the loan’s default rate – standard deviation of a
Bernoulli distribution.

 Correlation between returns of loans (ρij)

▪ Estimated as correlation between the systematic return components of the asset
returns of borrowers i and j.
▪ The model decomposes asset returns into systematic and unsystematic risk using
a three-level structural model.
Example 23

Suppose that an FI holds two loans with the following characteristics.

The correlation of return between the two loans is ρ12 = - 0.20;

Calculate of the return and risk on the two-asset portfolio using Moody’s
Analytics Portfolio Manager model.

The return and risk on loan 1 are:

R1 = (0.055 + 0.0225) - [0.035*0.30] = 6.70%
σ1 = [0.035(0.965)] ½ *0.30 = 5.513%
 Example 24

The return and risk on loan 2 are:

R2 = (0.035 + .0175) - [0.01*0.20] = 5.05%
σ2 = [0.01(0.99)] ½*0.20 = 1.990%

The return of the portfolio is then:

Rp = 0.45 (6.70%) + 0.55 (5.05%) = 5.7925%

The risk of the portfolio is then:

σp2 = (0.45)2(5.513%)2 + (0.55)2(1.990%)2 + 2(0.45)(0.55)(-0.20)(5.513%)(1.99%) =
0.0627%;
σp = (0.0627%)0.5 = 2.503%
Partial Applications of MPT 25

 Direct application of the modern portfolio theory (MPT) is often difficult

due to the lack of information on market prices of assets.

 However, we can still apply some of the implications from MPT in the loan
portfolio risk management. Recall the two important conclusions of MPT:
▪ Optimal risky portfolio: Market portfolio of risky assets is the optimal
portfolio of risky assets for anyone
▪ CAPM on Risk-return relationship for individual risky assets: the risk of an
individual asset is determined by its systematic risk as measured by beta (how
it co-moves with market)
Loan volume-based models
26

 Comparing the asset allocation in the loan portfolios to the market

benchmarks.
▪ Based on the implication from MPT that market portfolio is the optimal one
because of maximum diversification

 The following table shows an example of allocations of loans to different

sectors by two banks against the national benchmarks.
▪ The national benchmark may be inappropriate as the relevant benchmark for
a very small regional bank. In this case, the FI could construct a regional
benchmark.
Loan volume-based models
27
 Deviations from the market portfolio benchmark indicate the relative
degree of loan concentration:

σ𝑁
𝑖=1(𝑋𝑖𝑗 − 𝑋𝑖 )
2
𝜎𝑗 =
𝑁

where
σj = deviation of a bank’s jth asset allocation proportions from the national
benchmark
Xij = asset allocation proportion of the jth bank in ith loan sector/category
Xi = national asset allocation proportion in ith loan sector/category
N = number of loan sectors/categories
Loan volume-based models - Example 28

Bank A Bank B
(0.65 - 0.45)2 = 0.0400 (0.10 - 0.45)2 = 0.1225
(0.20 - 0.30)2 = 0.0100 (0.25 - 0.30)2 = 0.0025
(0.10 - 0.15)2 = 0.0025 (0.55 - 0.15)2 = 0.1600
(0.05 - 0.10)2 = 0.0025 (0.10 - 0.10)2 = 0.0000
= 0.0550 = 0.2850
A = 0.055/4 = 11.73% B = 0.285/4 = 26.69%

 Bank B deviates more significantly from national benchmark than Bank A.

 Is a large standard deviation necessarily bad for an FI?
Loan Volume-Based Models - Discussions 29

 Deviations from the national benchmark is not necessarily bad.

▪ An FI could have comparative advantages that are not required or available to
a national, well-diversified bank.
▪ Additionally, an FI could specialize in only one product, such as mortgages,
but be well diversified within this product line by investing in several different
types of mortgages that are distributed both nationally and internationally.

 However, the asset proportions derived nationally could still serve as a

good benchmark for detecting loan concentration risk.
▪ because it aggregates across all banks, the national composition of loan
portfolio represents a more diversified market portfolio
▪ As such, it is likely to be closer to the most efficient portfolio composition
than the allocation of the individual bank.
Loan Loss Ratio-Based Models 30

 Measure the loan risk of a sector by its contribution/sensitivity to the loss

of the aggregate loan portfolio

 Based on the implication of CAPM that an asset’s risk is determined by its

systematic risk – how its return co-move with market return
Loan Loss Ratio-Based Models
31
 Estimates the systematic loan loss risk of a sector by regressing the
historical loan loss ratio of the sector on the loan loss ratio of the total
loan portfolio

Sectoral losses in the ith sector  Total loan losses 

=  + i  
Loans to the ith sector  Total loans 
where:
α = loan loss rate for a sector with no sensitivity to losses on the aggregate
portfolio,
βi = systematic loss sensitivity of the ith sector loans to total loans.
Loan Loss Ratio-Based Models - Example 32

 Over the past 10 years, a finance company has experienced the following
loan losses on its C&I loans, consumer loans, and total loan portfolio.

 Based on regression analysis on these historical loan losses, the FI obtains

the following estimated coefficient estimates for the C&I loans sector and
Consumer loans sector:
𝑋𝐶&𝐼 = 0.003 + 0.75𝑋𝐿 ; 𝑋𝑐𝑜𝑛𝑠𝑢𝑚𝑒𝑟 = 0.005 + 1.25𝑋𝐿
Loan Loss Ratio-Based Models - Example 33

 With the following estimated coefficient estimates for the C&I loans
sector and Consumer loans sector:
𝑋𝐶&𝐼 = 0.003 + 0.75𝑋𝐿 ; 𝑋𝑐𝑜𝑛𝑠𝑢𝑚𝑒𝑟 = 0.005 + 1.25𝑋𝐿
▪ The C&I sector has a 𝛽 of 0.75, suggesting that the loan losses in the C&I
sector are systematically low relative to the total loan losses of the FI, while
for the Consumer sector, it is higher (𝛽 = 1.25).
▪ It is prudent for the FI to maintain lower concentration limits for the
Consumer sector as opposed to the C&I sector.

 The higher the beta ➔ the higher the correlation of a sector to the total
loan portfolio ➔ the lower the diversification benefits by having this
sector in the total loan portfolio.
Foreign Exchange Risk
Financial crises related to sovereign debts and 35
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
 Turkish currency and debt crisis (2018)
▪ https://en.wikipedia.org/wiki/Turkish_currency_and_debt_crisis,_2018
 The Currency Losses at NAB
(For your knowledge only) 36

 $360 million foreign exchange losses incurred by the NAB announced to

the market in January 2004.
▪ A group of traders went contrary to the NAB’s strategy.
▪ The risk exposure of the currency options desk to the US dollar
increased significantly in late 2003.
▪ They kept misreport the true the position to exceed risk limits.
▪ The high exposure resulted in significant losses when the US dollar fell
by some ten cents against the Australian dollar.
▪ http://www2.owen.vanderbilt.edu/nick.bollen/themes/pwcreport.pdf
Historical AUD Exchange Rates
AUD Exchange Rate 37
140 1.6000

1.4000
120

1.2000
100

1.0000
80

0.8000

60
0.6000

40
0.4000

20
0.2000

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
More Recent AUD Exchange Rates 38
AUD/USD
0.8500

0.8000

0.7500

0.7000

0.6500

0.6000
Quotation of FX Rates 39

 Direct quote: the price of the foreign currency expressed in terms of local
currency
 Indirect quote: the price of the local currency in terms of foreign currency

 Assume home country is Australia, which one of the following is a direct

quote?
1. USD 0.87/AUD
2. AUD 1.15/USD

▪ If not explicitly specified, we will be using the direct quotes by default and
Australia as the home country and AUD as the home country currency
Spot and Forward Exchange Rates 40

 Spot exchange rate: the rate for immediate exchange of currencies

at a specified rate.
 Forward exchange rate: the exchange of currencies at a specified
rate at some specified date in the future.
Foreign Exchange Risk of FI 41

 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).

 With greater integration of global markets, management of foreign

exchange risk has become increasingly important for FIs.

 Many FIs have greater hedging needs and speculative positions taken to
increase income.
FX Trading Activities of FI
42

FIs are involved in the purchase and sales of FX

1) to allow customers to partake in and complete international
commercial trade transactions
2) to allow customers (or the FI itself) to take positions in foreign real
and financial investments
3) for hedging purposes to offset customers’ (or the FI’s) exposure in
any given currency
4) for speculative purposes

 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.
Foreign Assets and Liabilities Positions
43

 FIs often hold foreign assets and liabilities.

 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)

 They acquire foreign assets and liabilities to

▪ diversify their sources and uses of funds
▪ exploit imperfections in foreign banking markets that create opportunities for
higher returns on assets or lower funding costs.
CBA’s Foreign Exchange Positions - 2019
44

“The Group has a high quality, well diversified credit portfolio, with 61% of the gross loans and
other receivables in domestic mortgage loans and a further 7% in overseas mortgage loans,
primarily in New Zealand. Overseas loans account for 14% of loans and advances.”
CBA’s Foreign Exchange Positions - 2019 45
CBA’s Foreign Exchange Positions - 2019
46
How to measure and manage foreign
exchange risk?
FX Exposure 48

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

𝑁𝑒𝑡 𝑒𝑥𝑝𝑜𝑠𝑢𝑟𝑒𝑖
= 𝐹𝑋 𝑎𝑠𝑠𝑒𝑡𝑠𝑖 − 𝐹𝑋 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠𝑖 + 𝐹𝑋 𝑏𝑜𝑢𝑔ℎ𝑡𝑖 − 𝐹𝑋 𝑠𝑜𝑙𝑑𝑖
= 𝑁𝑒𝑡 𝑓𝑜𝑟𝑒𝑖𝑔𝑛 𝑎𝑠𝑠𝑒𝑡𝑠𝑖 + 𝑁𝑒𝑡 𝐹𝑋 𝑏𝑜𝑢𝑔ℎ𝑡𝑖
FX Exposure of Australian FIs 49
FX Exposure – Continue 50

 Positive net exposure ➔ net long in a foreign currency ➔ The FI suffers

from depreciation in the foreign currency against the domestic currency

 Negative net exposure ➔ net short in a foreign currency ➔ The FI suffers

from appreciation in the foreign currency 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.
Return of Foreign Investments 51

 The returns of foreign investments are affected by:

▪ interest spread between the use of funds and the source of funds in
foreign country, i.e., net return in terms of foreign currency
▪ Fluctuations in FX rates.

 RD = (1 + RF) * (S1 / S0) – 1

▪ Where RD and RF 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.
Example 52

 Suppose an AU FI has the following assets and liabilities

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

Example 53

 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%, and end of year pound revenue is
£62.5*(1+15%)=£71.875 million.
▪ 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!
Hedging FX Risk 54

 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.

 Off-Balance-Sheet Hedging:
▪ Uses forwards, futures, or options.
▪ Pros: being off-BS; no immediate cash flows required, thus upfront cost is lower;
flexible.
▪ Cons: counterparty default risk, especially in the forward market

 Hedging via Multicurrency Foreign Asset–Liability Positions

▪ 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
Example 55

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

 The bank locks in a positive interest spread of 15% - 11% = 4%.

 This locks in a net interest income on U.K. loans of £62.50*4% = £2.5 million.
▪ The net interest income in UK loans is still exposed to FX risk.

 Note, Duration of assets= Duration of liabilities=1 year. (what if not?)

▪ Please check-What if the year end spot rate is $1.45/£1 (Depreciating pound) or
$1.70/£1 (Appreciating pound)?
Example
56

 Off-balance-sheet hedging with forwards

▪ 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) in
year) (9% interest rate) AUD, (8% interest rate).
$100 million equivalent U.K.
loans (1 year) made in pounds
(15% interest rate)
Example 57

 End-of-year dollar amount from UK loan when hedging with forwards

▪ Recall that the 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% or (1+15%)*1.55/1.60
– 1 = 11.41%
▪ And the return is fixed and locked in today!
 58

Theories on Foreign Exchange Rate

 Purchasing power parity theorem
 Interest rate parity theorem
Purchasing Power Parity (PPP) 59

 PPP establishes the link between inflation and FX rates

▪ 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., the value of the same amount of goods and
services should be equal when expressed in a common currency
▪ 𝑷𝒓𝒊𝒄𝒆𝑫 = 𝑺𝑫/𝑭 × 𝑷𝒓𝒊𝒄𝒆𝑭
▪ Hence, Exchange Rate (D/F) = S = PriceD / PriceF
▪ 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
Purchasing Power Parity (PPP) 60

 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.

Purchasing Power Parity (PPP), Cont’d 61

 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 (the “fisher effect”)
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.
Is it the case in practice?
Purchasing Power Parity (PPP) - Example 62

 Suppose the following:

▪ Spot exchange rate of U.S. dollar for Russian ruble is $0.17/₽

▪ Russian produced goods increase by 10 percent (inflation is 10% in
Russia)
▪ U.S. produced goods increase by 4 percent (inflation is 4% in US)
▪ What would happen to the exchange rate?
ΔS/S = iD – iF
➔ΔS = (0.04-0.10)*0.17=-0.0102
➔New exchange rate would be 0.1598 i.e. (0.17-0.0102)
➔ Ruble would depreciate against U.S. dollar
Interest Rate Parity Theorem (IRPT) 63

 IRPT describes the specific relationship that links spot exchange rate, interest
rate, forward exchange rate.

 The IRPT assumes no arbitrage in FX market – the following two investment

strategies should produce the same returns
1) Investing in domestic government securities, where the return is guaranteed at
(1+rD)
2) 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.
Interest Rate Parity Theorem (IRPT) 64

 By hedging in the forward exchange rate market, an investor realizes the

same returns whether investing domestically or in a foreign country:
𝐹𝑡
1 + 𝑟𝑡𝐷 = 1 + 𝑟𝑡𝐹
𝑆𝑡
▪ Where S and F are spot and forward exchange rate in direct quote.

 Another implication of IRPT: the spread between domestic and foreign

interest rates equals the percentage spread between forward and spot
exchange rates.
1 + 𝑟𝑡𝐷 𝐹𝑡 𝑟𝑡𝐷 − 𝑟𝑡𝐹 𝐹𝑡 − 𝑆𝑡
= ➔ =
1 + 𝑟𝑡𝐹 𝑆𝑡 1 + 𝑟𝑡𝐹 𝑆𝑡
▪ 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.
Interest Rate Parity Theorem: Application 65

 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/€,
what should be the 1-year forward exchange rate (Ft) based on
IRPT?

𝐹𝑡
 1 + 𝑟𝑡𝐷 = 1 + 𝑟𝑡𝐹
𝑆𝑡

▪ So F is $0.57/€ according IRPT.

 If the actual forward exchange rate is 0.59 instead, is AUD _______

in the spot currency market relative to the forward rate?
▪ 1) under-valued, 2) over-valued, or 3) fairly valued
Interest Rate Parity Theorem: Application 66

 $ is relatively overvalued
▪ Based on the IRPT and current spot rate, F should be $0.57/€ < the actual
forward rate $0.59/€ ➔ F in the market is too high ➔ 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) ➔ $ is relatively overvalued in the spot market.
▪ To verify this, substitute F = 0.59 into the IRPT formula ➔ S0 = $0.62/€ >
current spot rate ($0.6/€) ➔ € is relatively undervalued in the spot market,
which means $ is relatively overvalued.
Interest Rate Parity Theorem: Application
67

 Since the actual forward (spot) rate is higher (lower) than the IRPT-implied rate,
we have
0.59
1 + 5% < 1 + 10%
0.6
 We can design arbitrage trading strategy to taking advantage of this market
mispricing:
▪ It is profitable to convert $ to € in the spot market and invest in the foreign market.
Also, to cover the exchange rate risk, we need to sell the € proceeds forward for $ in
the forward market.
▪ So a complete trading strategy with say $1000 is:
1) borrow $1000 now in Australia, need to pay $1000(1+5%) = $1050 in one year
2) buy 1000/0.6 = €1,667 in the spot market and invest in the foreign market,
receive €1,667(1+10%)=€1,834
3) sell these € at the forward rate $0.59/€ now, which costs you nothing now, but
need to deliver €1,834*0.59 = $1,082 in one year
4) Net return = $1082 - $1050 = $32/$1000 = 3.2%