Foreign Exchange Risk Management

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Seminar for Senior Bank Supervisors

from Emerging Economies

Washington, DC October, 2002

Foreign Exchange Risk

Management

Perry D. Mehta Perry D. Mehta

Federal Reserve Bank of Richmond, Charlotte Office Federal Reserve Bank of Richmond, Charlotte Office

[email protected] [email protected]

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Outline

u

Features of the spot fx market

u

What determines exchange rates

u

Key risks to banks from their fx

positions

u

Measuring and managing fx risk

At all stages, we will consider

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Features of FX Markets

u Cash market turnover $1.5 trillion/day

l About 5 X combined $ volume of

NYSE, AMEX, NASDAQ, U.S. bond market

l Average transaction size up from $0.75 million in 80s

to $10 million

u Most liquid of all cash markets

l Very high trading frequency

l Very large transaction sizes do not affect price

u Continuous trading around the globe u Dominated by USD

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Major Players

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Dealers

l Commercial banks, investment banks

u

Brokers

l Commercial banks, investment banks

u

Other financial services firms

l Investment funds, insurance firms

u

Non-financial corporations

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Investment Objectives

Hedge Nonfinancial corporations Commercial banks

Investment banks

Investment funds; insurance cos. Supranationals

Speculate Commercial banks Investment banks

Arbitrage Commercial banks Investment banks

Meet customer needs

Commercial banks Investment banks

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Terminology

u

Transaction to exchange amount of one

currency for another

l Typically, an exchange of appropriate

amounts of banks deposits

u

The terms or price of the exchange =

exchange rate

l If 1 USD buys 0.68 GBP, then exchange rate is

0.68 GBP/USD or 1.47 USD/GBP

l If bank pays 1 USD for 0.68 GBP, it is long 0.68

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Transaction Types

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Cash / Spot

l Settled T+2 (T+1 for USD-CAD)

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Forward

l OTC settled in more than two days

u

Swaps: FX versus Currency

u

Exotic options

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Futures

u

Cash options

u

Futures options

OTC Exchange traded Derivatives

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Spot Transaction

u

AmeriBank buys £10 million worth of ¥ from

CanaBank (= ¥155.51 million)

u

Ameribank is long ¥155.51 mm, short £10 mm;

CanaBank has mirror-image positions

u

Ameribank will give irrevocable payment

order to its clearing agent to credit CanaBank’s

account £10 mm

l CanaBank will give irrevocable payment order

to its clearing agent to credit AmericBank’s account ¥155.51 mm

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Settlement Exposure: AmeriBank

0 T T+1 T+2 T+3 ¥ mm Time (days) 100 200 Sell £ for ¥ Irrevocable £ payment order Pay £ Receive ¥ Confirm ¥ receipt R I _U _{S or F} Status: R = Revocable I = Irrevocable U = Uncertain S = Settled F = Failed

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Settlement Risk

u

“Risk that one party to a foreign exchange

transaction will pay the currency it sold

but not receive the currency it bought”

u

Due to

l Time zone differences in settlement systems l Time period for settlement process

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Determinants of Exchange Rate

u Relative economic conditions

l Trade, balance of payments

u Political risks

l Capital controls, trade barriers, expropriation

u Purchasing Power Parity

l Static (spot rate)

l Dynamic (forward/ expected future spot)

u Interest Rate Parity

l Covered (forward rate)

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Purchasing Power Parity

u

Static:

l Exchange rate = 0.68 £/$ = 1.47 $/£

t Law of One Price = single good t PPP = consumption basket

u

Dynamic:

l Rate of appreciation of £ against $ is the

difference between inflation rates in the two countries

A loaf of bread

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Purchasing Power Disparities

u

Government

l Trade barriers l Capital controls l Exchange controls

l Other regulations - tax

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Industry

l Product quality perceptions l Supply reliability perceptions l Infrastructure deficiencies

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Over 3 mos

Today _{After 3 mos}

Interest Rate Parity

l Spot rate = 0.6800 £/$ or 1.4706 $/£

l 3-mo Eurodollar @ 5%, Eurosterling @ 4%

u

Spot rate in 3 mos? 3-mo forward rate today?

u Two investment alternatives:

l $1 1*(1+0.05/4) = $1.0125

l $1 $???

£0.68 0.68*(1+0.04/4) = £0.6868

u In 3 mos, £0.6868 = $1.0125, or e = 0.6783 £/$ = 1.4742 $/£

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Interest Rate Parity (2)

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Uncovered IRP

l Future movements of spot rate depend upon

interest rates in the two currencies

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Covered IRP

l The forward rate today depends upon interest

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Forward Hedge

u American importer must pay British firm £10mm in 3 months.

u Can purchase £ spot in 3 months

l Unknown e

u Can purchase £ forward. Advantages

-l No up-front $ payment

l Known exchange rate $1.4742 / £

In 3 months, pay $14.742 mm to fx dealer, and receive £10 mm to pay British supplier.

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Swaps

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FX Swap

l Two currency exchanges: first at value date,

and then opposite exchange at maturity date

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Currency Swap

l Stream of currency exchanges: each payment

based on the interest rate of that currency

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Other Derivatives

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Futures

l Exchange-traded version of forwards

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Cash Options

l Exchange-traded, usually European-style

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Futures Options

l Exchange-traded, usually American-style

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Futures

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Exchange-traded version of forward

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Standardized contract specifications

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Exchange is counterparty to both sides

l No counterparty credit risk

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Futures Daily Settlement

Long Position Date Quote $/£ Contract

Value Cash inflow Margin Call Margin Bal Margin Balance 26-Oct-00 1.4534 $90,838 -$7,000 $0 $7,000 $7,000 27-Oct-00 1.4621 $91,381 $544 $0 $7,544 $7,544 30-Oct-00 1.4402 $90,013 -$1,369 $0 $6,175 $6,175 31-Oct-00 1.4259 $89,119 -$894 $1,719 $7,000 $5,281 1-Nov-00 1.4435 $90,219 $1,100 $0 $6,381 $6,381 2-Nov-00 1.4568 $91,050 $831 $0 $7,213 $7,213

u GBP December futures contract

u Size = £62,500

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Option

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Call option

l Right, but not obligation, to purchase a fixed

quantity of the foreign currency, at a fixed price, at or before maturity.

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Put option

l … sell a fixed quantity of foreign currency …

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Example

l Call option on British pound, prices in US

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Call Option

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U.S. interest rate, r = 6%

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U.K. interest rate, r

_f

= 5%

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Current exchange rate, S = 0.68 $/£

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Volatility in value of £,

σ

= 15%

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Option expires in 3 months; T = 0.25

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Call Option Value

(T = 3 months)

0 0.05 0.1 0.15 0.2 0.25 1.2054 1.2642 1.323 1.3818 1.4406 1.4994 1.5582 1.617 1.6758 Underlying in $ Option Value in $ Call Instrinsic

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Call Delta, Gamma

(T = 3 months)

0 0.5 1 1.5 2 2.5 3 3.5 4 1.2054 1.2642 1.323 1.3818 1.4406 1.4994 1.5582 1.617 1.6758 Underlying in $ Gamma 0 0.2 0.4 0.6 0.8 1

Gamma Delta (right scale)

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Low T (1

-

day) Call

0 0.05 0.1 0.15 0.2 0.25 1.2054 1.2642 1.323 1.3818 1.4406 1.4994 1.5582 1.617 1.6758 Underlying in $ Option Value in $ Call Instrinsic

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Call Delta, Gamma

(T = 1 day)

0 2 4 6 8 10 1.2054 1.2642 1.323 1.3818 1.4406 1.4994 1.5582 1.617 1.6758 Underlying in $ Gamma 0 0.2 0.4 0.6 0.8 1

Gamma (1-day) Gamma (3-mth)

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Risks In FX Transactions

u Price (market) risk

l Interest rate movements u Credit risk l Counterparty default u Political risk l Capital controls l Expropriation u Operational Risk l IT systems l Economic Activity l Inflation rates l Settlement: Payments system l Trade barriers

l Tax, regulatory changes l Internal Controls

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Supervisory Review: Price Risk

u Position limits

l Transaction (spot, forward) l Counterparty

l Currency l Region

u VaR monitoring

l VaR limits by currency, region, product line

u Risk factor monitoring

l Greek limits: delta, gamma, vega

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Supervisory Review: Credit Risk

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Counterparty

l Position limits l Collateral

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Settlement system

l Netting: Obligation vs. Close-out;

Bilateral vs. Multilateral

l Upgrade correspondent bank services

t Latest possible cut-off time

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Supervisory Review: Political Risk

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Country risk monitoring

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Stress testing for event risk

l Expropriation l Tax changes

l Regulatory changes l Capital controls

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Supervisory Review:

Operational Risk

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IT Systems

l Systems integration

l Data input and transmission integrity

t Mix of manual and automated processes

l Incorporation of off-line deals

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Internal controls

l Audit of reporting trail

l Independence of risk measurement and

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References

u Foreign Exchange Committee (FXC) (private sector

group sponsored by Federal Reserve Bank of New

York) http://www.ny.frb.org/fxc/fxreport.html

l Guidelines for Foreign Exchange Trading Activity, 2001 l Foreign Exchange Transaction Processing: Execution to

Settlement - Recommendations for Nondealer Participants, 1999

u Committee on Payment and Settlement Systems of

Bank for International Settlements

http://www.bis.org/publ/cpsspubl.htm

l Survey of Electronic Money Developments, November 2001 l Core Principles for Systemically Important Payment Systems,

January 2001

l Current Topics in Payment and Settlement Systems, December