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BFF3651 Week 4

Risk Management:
Foreign Exchange
Risk
 Unit Learning Outcomes
• On successful completion of this unit, you should be able to:
– explain the role of treasury operations in an international
or a local bank
– describe how risk management processes work
– demonstrate the application of hedging techniques used in
banks' treasury operations
– apply critical thinking, problem solving and presentation
skills to individual and/or group activities dealing with
treasury management and demonstrate in an individual
summative assessment task the acquisition of a
comprehensive understanding of the topics covered by
BFF3651.

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 Resources
• Lecture note
• Saunders and Cornett’s Financial Institution
Management Chapter 13-Foreign Exchange Risk

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 Learning Objectives
• 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

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 Exchange rate

https://www.youtube.com/watch?v=O01TXv8fmfw

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 Learning Objectives
• 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

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 Foreign exchange rates and transactions

• Foreign Exchange Rate: price at which one currency can be

exchanged for another currency
• The foreign exchange market allows for the exchange of one currency
for another.
• Large commercial banks serve this market by holding inventories of
each currency, so that they can accommodate requests by individuals
or MNCs.
• Spot foreign exchange transactions: involve the immediate exchange
of currencies at the current (or spot) exchange rate. The market
where these transactions occur is known as the spot market.
• A treasurer should maintain good relationship with bank since banks
– Advice about current market conditions and forecasting
– Competitive quote
– Aarrange hard to find currencies

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 Foreign exchange rates and transactions
• A bank’s bid (buy) quote for a foreign currency will be less than its
ask (sell) quote.
• The bid/ask spread represents the differential between the bid and
ask quotes.
• Assume you have $1,000 and plan to travel to the United Kingdom,
bank’s bid rate for the British pound is $1.52 and its ask rate is
$1.60.
• If you convert $1,000 to pounds, you will get: $1,000/$1.60 = £625
• Now suppose that because of an emergency you cannot take the trip,
and you reconvert the £625 back to U.S. dollars. If the exchange
rate has not changed, you will receive: £625 x (Bank’s bid rate of
$1.52 per pound)= $950

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 Foreign exchange rates and transactions

• Direct quotation: represents the value of a foreign currency in

domestic currency (number of domestic currency per foreign
currency).
– Example: A direct quote would be USD/AUD if AUD is our
domestic currency. The exchange rate of AUD for dollar is 1.4.

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 Foreign exchange rates and transactions
• Indirect quotation: represents the number of units of a foreign currency
per domestic currency
– Example: The indirect quotation is the reciprocal of the direct
quotation:

Indirect quotation = 1/Direct quotation=$1/AUD1.4= 0.7, which

means $0.7 = AUD1
• Historically, foreign exchange required currencies to convert into U.S.
dollars and then into desired currencies
• Cross-currency trade: currency traders can bypass U.S. Dollars and
convert into desired currency directly

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Foreign exchange rates and transactions

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 Foreign exchange rates and transactions

• Forward foreign exchange transaction: exchange of currencies at a

specified exchange rate (or forward exchange rate) at some specified
date in the future.
• A forward contract specifies the amount of a particular currency
that will be purchased or sold by the firm at a specified future point
in time and at a specified exchange rate.
• Memphis Co. has ordered supplies from European countries that are
denominated in euros. It expects the euro to increase in value over
time and therefore desires to hedge its payables in euros. Memphis
buys forward contracts on euros to lock in the price that it will pay
for euros at a future point in time.

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 Foreign exchange rates and transactions

• Exchange rate movements:

• Depreciation: A decline in a currency’s value or currency becomes
weaker
• Appreciation: : An increase in a currency’s value or currency
becomes stronger

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 Learning Objectives
• 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

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 Sources of foreign exchange risk exposure
• Globalization of financial markets has increased the foreign
exchange exposure of most FIs.
– Through the holding of foreign currencies
– Through the holding of assets denominated in foreign currencies
(e.g., assets of overseas operations) and the issuing of liabilities
denominated in foreign currencies (e.g., issuing bonds in foreign
markets)
• Foreign exchange risk: The risk that exchange rate changes can
affect the value of a firm’s assets and liabilities denominated in non-
domestic currencies. Such fluctuations can also affect the value of
foreign currency held by the firm.
– 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).

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 Sources of foreign exchange risk exposure
• Net exposure: The degree to which net long (positive) or net short
position (negative) in a given currency
• Net exposure of an FI in a foreign currency i =NEXPi :
= (FX assetsi – FX liabilitiesi) + (FX boughti – FX soldi)
= Net foreign assetsi + Net FX boughti
Where:
i = ith currency
Net long in a currency: Net exposure > 0
Net short in a currency: Net exposure < 0
– Can you make net exposure = 0?
• The bank will lose if:
– it is long a currency (NEXPi > 0) and the currency depreciates in
value.
– if it is short a currency (NEXPi < 0) and the currency appreciates
in value.
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 Sources of foreign exchange risk exposure
• X-IM Bank has ¥14 million in assets, ¥23 million in
liabilities, and has sold ¥8 million in foreign currency
trading. What is the net exposure for X-IM? For what
type of exchange rate movement does this exposure put
the bank at risk?

• The net exposure would be ¥14 million – ¥23 million –

¥8 million = - ¥17 million. This negative exposure puts
the bank at risk of an appreciation of the yen against the
dollar. A stronger yen means that repayment of the net
position would require more dollars.

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 Sources of foreign exchange risk exposure
• 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. The
exchange rate of British pounds for U.S. dollars on June 15,
2015 was 0.6409. The U.S. dollar has depreciated in value
relative to the pound.
• Initial investment was $1 million x 0.6435 = ₤643,500
pounds.
• Exchanging the funds back to dollars on June 15, 2015 you
will have ₤643,500 pounds / 0.6409 = $1,004,057
• Your gain is $1,004,057 - $1,000,000 = $4,057.

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 Sources of foreign exchange risk exposure
• Commerce Bank’s (CB) home country is Great Britain and home
currency is the sterling pound.
• Current exchange rate is $US 1 = ₤ 0.6.
• Commerce Bank:
• $1,000 in assets (denominated in U.S. dollars)=worth 600 pounds.
• $250 in liabilities (denominated in U.S. dollars)=worth 150 pounds.
• If the exchange rate moved to $1 = ₤ 0.7,
1. assets increase in value by 100 pounds,
2. liabilities increase by 25 pounds,
3. bank’s equity would rise by 75 pounds.

• If the exchange rate moved to $1 = ₤ 0.5,

1. assets decrease in value by 100 pounds,
2. liabilities decrease by 25 pounds,
3. bank’s equity would decrease by 75 pounds.
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 Learning Objectives
• 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

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 Foreign currency trading
• 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

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 The Currency Losses at NAB
(For your knowledge only)

• Example of FX risk.
• Loss size: $600 million.
• Group of traders:
– Exceeded risk limits,
– Revalued trades for reporting, i.e., made unprofitable trades look
profitable,
– Engaged in fictitious transactions.

– https://www.smh.com.au/business/heads-roll-at-nab-over-foreign-exchange-
scandal-20040312-gdiizf.html

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 Learning Objectives
• 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

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 Foreign asset and liability positions
• Risk arises from mismatches between FI’s foreign
financial assets and foreign financial liabilities.
The Return and Risk of Foreign Investments:
• Returns are affected by:
– Difference between income and cost, i.e., return in
terms of foreign currency
– Fluctuations in FX rates.
• RDC = (1 + RFC) * (S1 / S0) – 1
– Where RDC and RFC 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 end of the investment period,
respectively.

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 Foreign asset and liability positions

Assume the following:

1. One year-CD rate is 8%
2. Default risk-free one year loans yield 9% in US; however, Default
risk-free one year loans yield 15% in UK
3. Beginning year Spot rate is $1.6/£1

Assets Liabilities
$200 million US CDs (1 year, 8%) in
$100 million (US loans-1 year, 9%) dollar

$100 million equivalent UK loans (1 year,

15%)

• Note, Duration of assets= Duration of liabilities=1 year.

• But note mismatching in currency composition of assets and
liabilities.

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 Foreign asset and liability positions

1. At the beginning of the year, sells $100 million for pounds on the
spot currency market at $1.60/£1. Translates to £62.5 million.
2. With this £62.5 million makes one-year UK loans at 15%
3. Year-end pound-revenue will be £62.5 (1+0.15)= £71.875 million
4. Repatriates funds back to US. If spot rate remains same at $1.6/£1,
then dollar proceeds from UK investment
=£71.875 million* $1.6/£1=$115 million
Rate of return from UK loan = (115-100)/100 = 15%
This equals to return of 15%
• Weighted average return on this strategy
=(0.5*0.09)+(0.5*0.15)=12%
• Exceeds the cost of funding by 4% (12%-8%)
• What if the year end spot rate is $1.45/£1 or $1.70/£1?

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 Foreign asset and liability positions

1. At the beginning of the year, sells $100 million for pounds on the
spot currency market at $1.60/£1. Translates to £62.5 million.
2. With this £62.5 million makes one-year UK loans at 15%
3. Year-end pound-revenue will be £62.5 (1+0.15)= £71.875 million
4. Repatriates funds back to US. At $1.45/£1, then dollar proceeds
from UK investment
=£71.875 million* $1.45/£1=$104.22 million
Rate of return from UK loan = (104.22-100)/100 = 4.22%
– Weighted average return on this strategy
=(0.5*0.09)+(0.5*0.0422)=6.61%
• Net return = (6.61%-8%)=-1.39%

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 Foreign asset and liability positions

1. At the beginning of the year, sells $100 million for pounds on the
spot currency market at $1.60/£1. Translates to £62.5 million.
2. With this £62.5 million makes one-year UK loans at 15%
3. Year-end pound-revenue will be £62.5 (1+0.15)= £71.875 million
4. Repatriates funds back to US. At $1.70/£1, then dollar proceeds
from UK investment
=£71.875 million* $1.70/£1=$122.19 million
Rate of return from UK loan = (122.19-100)/100 = 22.19%
– Weighted average return on this strategy
=(0.5*0.09)+(0.5*0.2219)=15.6%
• Net return = (15.6%-8%)=7.6%

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 Foreign asset and liability positions
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.
Consider the previous example with some change in funding composition

Assets Liabilities
$100 million (US loans-1 year)-9% $100 million US CDs (1 year) in dollar-8%

$100 million UK CDs (1 year)-11%

$100 million equivalent UK loans (1 year)-15% (Deposit raised in pounds)

Note, Duration of assets= Duration of liabilities=1 year. (what if

not?)
Also note matching in currency composition of assets and liabilities.

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 Foreign asset and liability positions: On balance sheet Hedging
UK CD
1. At the beginning of the year, borrows $100 million equivalent pound in
CDs for one year @11% with spot rate of $1.60/£1. Translates to £62.5
million.
2. Year-end CD pound-cost will be £62.5 (1+0.11)= £69.375 million
3. At $1.45/£1 spot rate at the end of the year, the cost will be £69.375 x
$1.45/£1 = $100.59 million or 0.59%
UK LOan
1. At the beginning of the year, sells $100 million for pounds on the spot
currency market at $1.60/£1. Translates to £62.5 million.
2. Year-end pound-revenue will be £62.5 (1+0.15)= £71.875 million
3. Repatriates funds back to US. If spot rate remains same at $1.45/£1,
then dollar proceeds from UK investment
=£71.875 million* $1.45/£1=$104.22 million or 4.22%
Net effect:
• WAROA = .5 x 0.09 + .5 x 0.0422 =6.61%
• WACOF= .5 x 0.08 + .5 x 0.0059 = 4.295%
• Net return = 6.61%-4.295% = 2.315%

Try if exchange rate becomes $1.70/£1

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 Foreign asset and liability positions: On balance sheet Hedging
UK CD
1. At the beginning of the year, borrows $100 million equivalent
pounds in CDs for one year @11% with a spot rate of $1.60/£1.
Translates to £62.5 million.
2. Year-end CD pound-cost will be £62.5 (1+0.11)= £69.375 million
3. At $1.70/£1 spot rate at the end of the year, the cost will be
£69.375 x $1.70/£1 = $117.94 million or 17.94%
UK Loan
1. At the beginning of the year, it sells $100 million for pounds on the
spot currency market at $1.60/£1. Translates to £62.5 million.
2. Year-end pound-revenue will be £62.5 (1+0.15)= £71.875 million
3. Repatriates funds back to the US. If the spot rate remains the same
at $1.70/£1, then dollar proceeds from UK investment
=£71.875 million* $1.70/£1=$122.19 million or 22.19%
Net effect:
• WAROA = .5 x 0.09 + .5 x 0.2219 =15.6%
• WACOF= .5 x 0.08 + .5 x 0.1794 = 12.97%
• Net return = 15.6%-12.97% = 2.63%

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 Foreign asset and liability positions
Off-Balance-Sheet Hedging: Lower costs alternative

• Uses forwards, futures, or options.

• Example: hedging US$100 million foreign asset position with 1-year

maturity by taking a short position in the forward market – selling
foreign currencies for domestic currencies in 1 year.

• The role of forward FX contract is to offset the uncertainty regarding

the future spot rate at the end of the investment horizon.

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 Foreign asset and liability positions
Hedging via Multicurrency Foreign Asset–Liability Positions
• Hedging does not necessarily require an FI to hedge
positions in individual foreign currencies one by one.
• 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.

• Limitation: Global integration, taxes, information

inefficiency

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 Learning Objectives
• 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

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 Purchasing Power Parity (PPP)

PPP: Attempts to quantify the inflation–exchange rate

relationship
Example:
1000AUD = 4000CNY
1AUD = 4CNY
Spot Exchange Rate, S = Price $D / Price $F
If 1AUD buys same good in China by spending 4CNY>PPP
A Big Mac costs 6.55 in Australia and 21.70 yuan in China.
Approximate exchange rate: 1AUD = 4CNY
https://www.economist.com/news/2020/07/15/the-big-mac-index

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 Purchasing Power Parity (PPP)

• If a country’s inflation rate increases relative to the countries with

which it trades, the country’s currency purchasing power declines.
• The exchange rate should be determined based on the
purchasing power of currencies.
• In equilibrium, real rates of interest should be equal across
countries, and therefore, differences in nominal interest rates
reflects differences in inflation rates across countries
• 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 may not be the
case.

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 Purchasing Power Parity (PPP)

• Change in exchange rates between two countries is proportional to

the difference in the inflation rates in two countries
• InflationD – InflationF = ΔSD/F / SD/F
• If inflation changes, price level changes leading to change in trade
flows and demand and supply of currencies.
• Suppose the following:
– Spot exchange rate: U.S. dollar for Russian Rubles 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 (0.17-0.0102).
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 Purchasing Power Parity (PPP)

• Suppose that the current spot exchange rate of U.S. dollars for
Australian dollars is 1.0277. The price of Australian-produced
goods increases by 5 percent and the U.S. price index increases
by 3 percent. Calculate the new spot exchange rate of U.S.
dollars for Australian dollars that should result from the
differences in inflation rates.

• ΔS= -(0.02) × 1.0277 = -0.020554

• Thus, it costs 2.0554 cents less to receive an Australian dollar.
The Australian dollar depreciates in value by 2 percent against
the U.S. dollar as a result of its higher inflation rate.

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 Interest Rate Parity Theorem (IRPT)

• 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 as (1+ RDC)
• 2. Investing in foreign government securities which guarantees a
return of (1+ RFC) 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
• RDC +1 = (1 + RFC) * (F/ S0)

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 Interest Rate Parity Theorem (IRPT)

• Hence IRPT states that the Discounted spread between

domestic and foreign interest rates equals the percentage spread
between forward and spot exchange rates.
• RDC +1 = (1 + R FC) * (F/ S0)
• (RDC +1)/ (1 + RFC) = F/ S0
• (RDC - RFC)/ (1+RFC) = (F- S0) / S0

• Where S0 and F are spot and forward exchange rate in direct

quote.
• 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. So, when you will convert to domestic currency, you
will not get additional return.

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 Interest Rate Parity Theorem (IRPT)

• 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/€1
• What should be the 1-year forward exchange rate (Ft) based
on IRPT?
(rD-rF)/(1+rF) = (F- S0)/ S0
 So F is $0.57/€1 according IRPT.
 Proof: let assume, you invest $1= €1.67 and after 1,
year, you earn: €1.67 x 1.1= €1.837. When you convert
to Australian dollar, you get: €1.83 x 0.57 = AUD1.05.
Rate of return = 5%. Thus, your hedged rate of return
is equal to your domestic rate of return. You can not
make a risk-free return.
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 Interest Rate Parity Theorem (IRPT)

• If the forward exchange rate is 0.59 instead, is the domestic

currency under-valued, over-valued, or fairly valued in the spot
currency market relative to the forward exchange rate?
• Based on the current spot rate, the forward rate should be
0.57 which is lower than the actual forward rate 0.59. So €
is overpriced with respect to $ in the forward market
relative to the spot market.
• This means € is undervalued in the spot market relative to
the forward market – and thus $ is relatively overvalued in
the spot market.
• To verify this: (rD-rF)/(1+rF) = (F- S0)/ S0
• So based on F = 0.59, S0 should be 0.615 > current spot
rate (0.60). So € is relatively undervalued in the spot
market, which means $ is relatively overvalued.

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 Conclusion
• 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

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