06 Aug What are four FX risks faced by FIs?
1st assignment:
What are four FX risks faced by FIs?
What is the spot market for FX? What is the forward market for FX? What is the position of being net long in a currency?
Refer to Table 13-1.
a. What was the spot exchange rate of Canadian dollars for U.S. dollars on June 15, 2015?
b. What was the six-month forward exchange rate of Japanese yen for U.S. dollars on June 15, 2015?
c. What was the three-month forward exchange rate of U.S. dollars for Swiss francs on June 15, 2015?
4. On May 15, 2015, you purchased a British pound-denominated CD by converting $1 million to pounds at a rate of 0.6435 pounds for U.S. dollars. It is now June 15, 2015. Has the U.S. dollar appreciated or depreciated in value relative to the pound?
a. Using the information in part (a), what is your gain or loss on the investment in the CD? Assume no interest has been paid on the CD.
5. On May 15, 2015, the exchange rate of U.S. dollars for Canadian dollars was 0.8095. It is now June 15, 2015. The U.S. made Chevrolet Tahoe costs $65,000 over the entire period. Has the U.S. dollar appreciated or depreciated in value relative to the pound? Is it cheaper or more costly for a Canadian citizen to buy the car (converting pounds into U.S. dollars) on June 15, 2015? What is the Canadian citizen’s C$ gain or loss on the purchase of the car if he waits to buy on June 15?
Write a 3-5 page essay (excluding title, abstract, and reference pages) including at least two peer-reviewed sources that are properly cited and referenced. The assignment should be APA compliance.
2nd different assignment is:
I need you to do a brief summary of the important concepts from these chapters.
Here are the files for 2nd assignment.
Requirements: I wrote it
Chapter 13Foreign Exchange Risk© McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.
13-2© McGraw-Hill Education.Overview•Foreign exchange rates and transactions•Sources of foreign exchange risk exposure •Foreign currency trading •Foreign asset and liability positions •Interaction of interest rates, inflation, and exchange rates
13-3© McGraw-Hill Education.Background•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 position as trader in foreign currency market)
13-4© McGraw-Hill Education.Foreign Exchange Rate•Price at which one currency can be exchanged for another–Direct quote: U.S. dollars received per unit of foreign currency exchanged▪Example: US$0.8972 per Canadian dollar (C$)–Indirect quote: Foreign currency received per U.S. dollar exchanged▪Example: C$1.1146 per US$•Note that the terms directand indirectdepend on where the quote is obtained –Direct quotes in Canada would be expressed in terms of C$ per unit of foreign currency
13-5© McGraw-Hill Education.Foreign Exchange Transactions•Spot foreign exchange transaction•Forward foreign exchange transactions•FI may be net long or net short in a currency
13-6© McGraw-Hill Education.FX Risk Exposure (1 of 2)•FI may have positions in spot and forward markets–Could match foreign currency assets to 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 to FX risk
13-7© McGraw-Hill Education.FX Risk Exposure (2 of 2)•Greater net exposure in foreign currency combined with greater volatility of the foreign -rate results in larger potential for losses/gains•Dollar loss/gain in currency i=[Net exposure in foreign currency in U.S. $]×Shock (Volatility) to the $/Foreign currency iexchange rate
13-8© McGraw-Hill Education.Web Resources •For statistics related to FX trading, visit:Bank for International Settlements www.bis.org
13-9© McGraw-Hill Education.FX Trading•FX markets turn over as high as $5.3 trillion per day•The market moves between Tokyo, New York, and London over the day, allowing for what is essentially a 24-hour market•Growth in electronic FX trading–More than 70% of global FX trading•Overnight exposure adds to the risk
13-10© McGraw-Hill Education.Trading Activities•Basically, 4 trading activities:–Purchase and sale of foreign currencies to complete international transactions–Facilitating positions in foreign real and financial investments–Accommodating hedging activities–Speculation•Substantial risk arises via open positions
13-11© McGraw-Hill Education.Profitability of FX Trading•For large US banks, trading income may be a major source of income–Market making, or acting as agents of customers, is only a secondary revenue stream–Citigroup, Bank of America, and J.P. Morgan Chase dominant in FX trading–Most risk arises from taking open positions in currencies
13-12© McGraw-Hill Education.Foreign Assets and Liabilities •Mismatches between foreign financial asset and liability portfolios•Ability to raise funds from internationally diverse sources presents opportunities, as well as risks–Exploit market imperfections in foreign banking markets▪Could result in higher return on assets or lower funding costs
13-13© McGraw-Hill Education.Return and Risk of Foreign Investments•Returns are affected by:–Spread between costs and revenues–Changes in FX rates can dramatically alter returns•Changes in FX rates are not under the control of the FI–Similarities with exposure to interest rate risk
13-14© McGraw-Hill Education.Risk and Hedging•Hedge can be constructed on-or off-balance-sheet–On-balance-sheet hedge involves changes to on-balance-sheet assets and liabilities to protect against FX risk–Off-balance-sheet hedge occurs via position in forward or other derivatives▪Example: Sell the expected proceeds of a British pound loan forward, eliminating future spot FX risk
13-15© McGraw-Hill Education.Multicurrency Positions•Since the banks generally take positions in more than one currency simultaneously, their risk is partially reduced through diversification•Real interest rate: Difference between nominal rate and expected rate of inflation
13-16© McGraw-Hill Education.Diversification Effects•If domestic and foreign interest rates or equity returns aren’t highly correlated over time, potential gains from asset-liability portfolio diversification may offset mismatching risk •Nominal return =real interest rate in country i + E[inflation] in country i
13-17© McGraw-Hill Education.Purchasing Power Parity•In equilibrium, real rates of interest should be equal across countries–Therefore, differences in nominal interest rates reflects differences in inflation rates across countries–FX rates should adjust in response to differences in inflation rates
13-18© McGraw-Hill Education.Interest Rate Parity Theorem•Equilibrium condition is that there should be no arbitrage opportunities available through lending and borrowing across currencies, which requires that•Difference in interest rates will equal the percentage spread between forward and spot exchange rates
13-19© McGraw-Hill Education.Pertinent Websites•Federal Reserve Bank www.federalreserve.gov•Citigroup www.citigroup.com •J.P. Morgan Chase www.jpmorganchase.com•Bank of America www.bankofamerica.com
© McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.13-20End of Presentation
Chapter 14Sovereign Risk© McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.
14-2© McGraw-Hill Education.Introduction (1 of 3)•Sovereign risk–Risk that repayments from foreign borrowers may be interrupted because of interference from foreign governments•In the1970s:–Expansion of loans to Eastern European, Latin America, and other LDCs
14-3© McGraw-Hill Education.Introduction (2 of 3)•Beginning of the 1980s:–Debt moratoria announced by Brazil and Mexico–Increased loan loss reserves–Citicorp set aside additional $3 billion in reserves•Early 2000s–Concerns over Argentina and Turkey
14-4© McGraw-Hill Education.Introduction (3 of 3)•Late 2000s, economies plummeted–Developed countries faced some of the worst declines in GDP ever experienced–IMF pledged to inject $250 billion •Greece debt crisis, 2009-2012–Crisis in Greece spread to Portugal, Spain, and Italy•Multiyear restructuring agreements (MYRAs)
14-5© McGraw-Hill Education.Credit Risk versus Sovereign Risk•Governments can impose restrictions on debt repayments to outside creditors (i.e., sovereign/country risk)–Loan may be forced into default even though borrower had a strong credit rating at origination of loan–Legal remedies are very limited•Emphasizes the need to assess credit risk andsovereign risk
14-6© McGraw-Hill Education.Debt Repudiation versus Debt Rescheduling•Repudiation–Since WWII, only China, Cuba, and North Korea have repudiated debt–Recent steps to forgive debts of most severe cases conditional on reforms targeted to improve poverty problems•Rescheduling–Most common form of sovereign risk, involves declaration of moratorium on current/future debt obligations–South Korea, Argentina, and Greece
14-7© McGraw-Hill Education.Debt Rescheduling•More likely to occur with international loan financing rather than bond financing–Smaller number of lending parties in international lending syndicate –Consensus is easier due to most international loan syndicates being made up of the same group of FIs–Cross-default provisions–Behavior of governments and regulators in lending countries
14-8© McGraw-Hill Education.Country Risk Evaluation (1 of 2)•Outside evaluation models:–EuromoneyCountry Risk (ECR) index–The Economist Intelligence Unit▪Highest risk in countries in 2015 are Syria, Somalia, Venezuela, and Sudan –Institutional Investor Index▪2015 placed Switzerland at least chance of default and Somalia at highest▪U.S. not the lowest risk
14-9© McGraw-Hill Education.Country Risk Evaluation (2 of 2)•Internal Evaluation Models –Statistical models▪Country risk-scoring models based primarily on economic ratios▪The selected variables are tested for predictive power in separating rescheduling countries from non-rescheduling countries using past data
14-10© McGraw-Hill Education.Web Resources•To learn more about the Economist Intelligence Unit’s country ratings, visit:The Economistwww.economist.com
14-11© McGraw-Hill Education.Statistical Models•Commonly used economic ratios:–Debt service ratio = (Interest + amortization on debt)/Exports–Import ratio = Total imports / Total FX reserves–Investment ratio = Real investment / GNP•Discriminant function:p=f(DSR, IR, INVR, VAREX, MG,…)
14-12© McGraw-Hill Education.Problems with Statistical CRA Models (1 of 2)•Measurements of key variables•Population groups–Finer distinction than reschedulersand nonreschedulersmay be required•Political risk factors may not be captured–Strikes, corruption, elections, revolution–Index of Economic Freedom or Corruption Perceptions Index
14-13© McGraw-Hill Education.Problems with Statistical CRA Models (2 of 2)•Portfolio aspects–Many large FIs with sovereign risk exposures diversify across countries–Diversification of risks not necessarily captured in CRA models •Incentive aspects–Borrowers and Lenders▪Costs and benefits•Stability–Model likely to require continuous updating
14-14© McGraw-Hill Education.Using Market Data to Measure Risk•Secondary market for LDC debt–Sellers and buyers•Current market for sovereign debt–Sovereign bonds–Performing loans–Nonperforming loans
14-15© McGraw-Hill Education.Pertinent Websites•Bank for International Settlements www.bis.org•Heritage Foundation www.heritage.org•Institutional Investor www.institutionalinvestor.com •International Monetary Fund www.imf.org •The Economist www.economist.com •Transparency International www.transparency.org •World Bank www.worldbank.org
14-16© McGraw-Hill Education.Mechanisms for Dealing with Sovereign Risk Exposure•Alternative mechanisms to handle problem sovereign credits once they have arisen–Debt-for-equity swaps–Multiyear restricting of loans (MYRAs)–Sale of LDC loans on the secondary market–Bond-for-loan swaps
14-17© McGraw-Hill Education.Debt-for-Equity Swaps•Debt-for-equity swaps–Examples: ▪Citigroup sells $100 million Chilean loan to Merrill Lynch for $91 million▪Bank of America (market maker) sells to IBM at $93 million▪Chilean government allows IBM to convert the $100 million face value loan into pesos at a discounted rate to finance investments in Chile
14-18© McGraw-Hill Education.MYRAs•Aspects of MYRAs:–Fee charged by bank for restructuring–Interest rate charged on new loan is generally lower than rate on original loan–Grace period may apply–Maturity of loan is lengthened–Option and guarantee features•Concessions for FI are larger the lower the PV of restructured loan relative to original
14-19© McGraw-Hill Education.Other Mechanisms•Loan sales–Removal of loans from balance sheet and signal that remainder of balance sheet is sufficiently strong–Major cost is the loss itself•Bond-for-loan swaps–Transform loan into highly marketable and liquid instrument –a bond!–Usually possess senior status to remaining loans
© McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.14-20End of Presentation
