Anthony Saunders and Marcia Millon Cornett, Financial Institutions Management: A Risk Management Approach

Transcription

1 P1.T3. Financial Markets & Products Anthony Saunders and Marcia Millon Cornett, Financial Institutions Management: A Risk Management Approach Bionic Turtle FRM Study Notes Sample By David Harper, CFA FRM CIPM and Deepa Raju

2 Saunders, Chapter 13: Foreign Exchange Risk CALCULATE A FINANCIAL INSTITUTION S OVERALL FOREIGN EXCHANGE EXPOSURE EXPLAIN HOW A FINANCIAL INSTITUTION COULD ALTER ITS NET POSITION EXPOSURE TO REDUCE FOREIGN EXCHANGE RISK... 5 CALCULATE A FINANCIAL INSTITUTION S POTENTIAL DOLLAR GAIN OR LOSS EXPOSURE TO A PARTICULAR CURRENCY... 5 IDENTIFY AND DESCRIBE THE DIFFERENT TYPES OF FOREIGN EXCHANGE TRADING ACTIVITIES.. 5 2

3 Saunders, Chapter 13: Foreign Exchange Risk Calculate a financial institution s overall foreign exchange exposure. Explain how a financial institution could alter its net position exposure to reduce foreign exchange risk. Calculate a financial institution s potential dollar gain or loss exposure to a particular currency. Identify and describe the different types of foreign exchange trading activities. Identify the sources of foreign exchange trading gains and losses. Calculate the potential gain or loss from a foreign currency denominated investment. Explain balance sheet hedging with forwards. Describe how a non arbitrage assumption in the foreign exchange markets leads to the interest rate parity theorem; use this theorem to calculate forward foreign exchange rates. Explain why diversification in multicurrency asset liability positions could reduce portfolio risk. Describe the relationship between nominal and real interest rates. Foreign Exchange Rates A foreign exchange rate is the price at which one currency (e.g., the U.S. dollar) can be exchanged for another currency (e.g., the Swiss franc). According to Saunders, foreign exchange rates are listed in two ways, direct or indirect. A direct quote gives U.S. dollars received for one (1.0) unit of foreign currency exchanged. An indirect quote gives units of foreign currency received for one U.S. dollar. For example: Direct quote (aka, US$ Equivalent) For example, on July 4, 2012, the exchange rate of U.S. dollars for Canadian dollars was $ or USD per one Canadian dollar. Indirect quote (Currency per US$) Conversely, the exchange rate of Canadian dollars for each U.S. dollar was CAD per one U.S. dollar, which of course is approximately equal to 1/ However, it is perhaps more important to understand the common market convention for quoting currency pairs. In the market, the currency pair is quoted as base/quote where the first currency is the base currency and the second currency is the quote currency. The exchange rate, then, gives the number of units of the quote currency per one unit of the base currency. For example, in the currency pair EUR/USD 1.23 or EURUSD 1.23, EUR is the base currency (it is first) and U.S. dollars is the quote currency (it appears second). So, this refers to $1.23 U.S. dollars per one EUR. Note this can be confusing because the / does not denote a ratio, and is often omitted. 3

4 Calculate a financial institution s overall foreign exchange exposure. FX position exposure An FI s overall FX exposure in any given currency can be measured by the net position exposure, which is measured in local currency as = ( ) + ( ) = +. where = th currency Positive net exposure net long a currency. Negative net exposure net short a currency. A positive net exposure position implies a U.S. FI is overall net long in a currency (i.e., the FI has bought more foreign currency than it has sold) and faces the risk that the foreign currency will fall in value against the U.S. dollar, the domestic currency. A negative net exposure position implies that a U.S. FI is net short in a foreign currency (i.e., the FI has sold more foreign currency than it has purchased) and faces the risk that the foreign currency could rise in value against the dollar. Thus, failure to maintain a fully balanced position in any given currency exposes a U.S. FI to fluctuations in the FX rate of that currency against the dollar. Indeed, the greater the volatility of foreign exchange rates given any net exposure position, the greater the fluctuations in value of an FI s foreign exchange portfolio. The table below replicates Saunders Table The net position of each currency is the sum of (assets minus liabilities) and (FX Bought minus FX Sold). For example, in the case of Japanese yen (59,620-54,591) + (471, ,227) = -4,950. 4

5 Explain how a financial institution could alter its net position exposure to reduce foreign exchange risk To reduce its foreign currency exposure: An FI could match its foreign currency assets to its liabilities in a given currency and match buys and sells in its trading book in that foreign currency to reduce its foreign exchange net exposure to zero and thus avoid FX risk. FIs could also offset an imbalance in its foreign asset liability portfolio by an opposing imbalance in its trading book so that its net exposure position in that currency would be zero. Further, financial holding companies can aggregate their foreign exchange exposure even more. Financial holding companies might have a commercial bank, an insurance company, and a pension fund all under one umbrella that allows them to reduce their net foreign exchange exposure across all units. Calculate a financial institution s potential dollar gain or loss exposure to a particular currency We can measure the potential size of an FI s FX exposure by analyzing the asset, liability, and currency trading mismatches on its balance sheet and the underlying volatility of exchange rate movements. Specifically, the potential size of a bank s FX exposure given by: / = [ $ ( ) $ The larger the FI s net exposure in a foreign currency and the larger the foreign currency s exchange rate volatility, the larger is the potential dollar loss or gain to an FI s earnings. The underlying causes of FX volatility reflect fluctuations in the demand for and supply of a country s currency. That is, conceptually, an FX rate is like the price of any good and will appreciate in value relative to other currencies when demand is high or supply is low and will depreciate in value when demand is low or supply is high. Identify and describe the different types of foreign exchange trading activities A bank s position in the FX markets generally reflects four trading activities. It involves the purchase and sale of foreign currencies: 1. To allow customers to 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 customer (or FI) exposure in any given currency. 4. For speculative purposes, to forecast or anticipate future movements in FX rates. 5