FRM Markets & Products Saunders & Cornett, Chapter 14: Foreign Exchange Risk

Transcription

1 FRM Markets & Products Saunders & Cornett, Chapter 14: Foreign Exchange Risk Hosted by David Harper CFA, FRM, CIPM Published April 14, 2012 Brought to you by bionicturtle.com This tutorial is for paid members only. You know who you are. Anybody else is using an illegal copy and also violates GARP s ethical standards.

2 2012 FRM Markets and Products 3.d Related Learning Spreadsheets Spreadsheet 3.d.3. FX hedges (Saunders) Exam Relevance (XLS not topic) Low 2

3 Saunders & Cornett, Chapter 14: Foreign Exchange Risk 3

4 Foreign Exchange Rates Direct quote (US$ Equivalent) U.S. dollars per one unit of foreign currency USD / CAD Indirect quote (Currency per US$) Foreign currency per one US dollar CAD / $USD 4

5 Calculate a financial institution s overall foreign exchange exposure. Net exposure i = (FX assets i - FX liabilities i ) + (FX bought i - FX sold i ) = Net foreign assets i + Net FX bought i i = I th currency Positive net exposure: net long a currency Negative net exposure: net short a currency 5

6 Demonstrate how a financial institution could alter its net position exposure to reduce foreign exchange risk. Net exposure i = (FX assets i - FX liabilities i ) + (FX bought i - FX sold i ) = Net foreign assets i + Net FX bought I Bank can match its foreign currency assets to its liabilities Bank can match buys and sells in trading book Financial holding companies can aggregate their foreign exchange exposure; e.g., under one umbrella, commercial bank, insurance company, pension fund 6

7 Calculate a financial institution s potential dollar gain or loss exposure to a particular currency. Dollar loss/gain in currency i = [Net exposure in foreign currency i ] measured in US dollars shock (volatility) to $/foreign currency i exchange rate 7

8 List and describe the different types of foreign exchange trading activities. Purchase/sale of foreign currencies 1. To allow customers to participate in international commercial trade transactions 2. To allow customers to take positions in foreign investments (real or financial assets) 3. For hedging purposes i.e., to offset currency exposure 4. For speculative purposes 8

9 Identify sources of foreign exchange trading gains and losses. In the first two activities (To allow customers to participate in international commercial trade transactions; To allow customers to take positions in foreign investments, real or financial assets), the bank normally acts as an agent of its customers for a fee but does not assume the FX risk itself. In the third activity (For hedging purposes i.e., to offset currency exposure), the bank acts defensively to reduce FX exposure. Consequently, the primary FX exposure essentially relates to open positions taken as a principal by the bank for speculative purposes 9

10 Calculate the potential gain or loss from a foreign currency denominated investment. 3.d.3 Unhedged Assets (loans) Liabilities (CDs) Invest: Lend: $ US 9% $ US 8% $ % $ % $/ Start $1.60 End $1.45 $ $ $ $ % 0.00% ROA 6.61% COF 8.00% ROI -1.39% 10

11 Calculate the potential gain or loss from a foreign currency denominated investment. Balance sheet hedge: UK Pound depreciates 3.d.3 Assets (loans) Liabilities (CDs) Invest: Lend: $ US 9% $ US 8% $ % $ % $/ Start $1.60 End $1.45 $ $ $ $ % 0.59% ROA 6.61% COF 4.30% ROI 2.31% 11

12 Calculate the potential gain or loss from a foreign currency denominated investment. Balance sheet hedge: UK Pound appreciates 3.d.3 Assets (loans) Liabilities (CDs) Invest: Lend: $ US 9% $ US 8% $ % $ % $/ Start $1.60 End $1.70 $ $ $ $ % 17.94% ROA 15.59% COF 12.97% ROI 2.63% 12

13 Explain balance sheet hedging with forwards. 3.d.3 Off balance sheet hedge with forwards Assets (loans) Liabilities (CDs) Invest: Lend: $ % $ % 15% 11% $/ Spot $1.60 Discount $0.05 Forward $1.55 $ % Returned ( ) Returned ($) $ Loan Return 11.41% ROA 10.20% COF 8.00% ROI: 2.20% 13

14 Use this theorem to calculate forward foreign exchange rates. 1 1 r 1 r F D L ust S ukt t t 1 r D ust 1 + interest rate on US CDs S t 1 r L ukt $ spot exchange rate at time t 1 + interest rate on U.K. loans F t $ forward exchange rate at time t 14

15 Explain why diversification in multicurrency asset -liability positions could reduce portfolio risk. To the degree that domestic and foreign interest rates (or stock returns) are not perfectly correlated, potential gains from asset -liability portfolio diversification can offset risk of asset -liability currency mismatch 15

16 Describe the relationship between nominal and real interest rates. Nominal interest rate = real interest rate + expected inflation rate r rr i e i i i ri The nominal interest rate in country i rri The real interest rate in country i e i The expected one-period inflation rate in country i i 16