Risk Management with Derivatives and Foreign Exchange Markets

Managing Risk off the Balance Sheet

!Managers are increasingly turning to off balance- sheet (OBS) instruments such as forwards, futures, options, and swaps to hedge the risks their financial institutions (FIs) face !!interest rate
risk !!foreign exchange risk !!credit risk !FIs also generate fee income from derivative securities transactions
Managing Risk off the Balance Sheet
!A spot contract is an agreement to immediately exchange assets and funds !A forward contract is a negotiated agreement to transact at a point in the future with the terms of the deal set
today !!Any amount can be negotiated !!Not generally liquid, so each party must perform !!Counterparty default risk can be significant
Futures Contracts
!Exchange-traded agreements to transact involving the future exchange of a set amount of assets for a price that is fixed today !!Futures are liquid, most traders close their position before
the delivery date so the underlying transaction may never take place !!Marked to market daily: the traders gains and losses on outstanding futures contracts are realized each day as futures
prices change !!Exchange clearinghouse stands behind all contracts so there is no counterparty default risk and trading is anonymous
Hedging with Forwards
!A nave hedge is a hedge of a cash asset on a direct dollar-for-dollar basis with a forward (or futures) contract ! Managers can predict capital loss (!P) using the duration formula:
! FIs can immunize assets against risk by using hedging to fully protect against adverse movements in interest rates !P = "DP !R (1+ R) where P = initial asset value D = asset duration R =
interest rate (!R = rate change)
Hedging with Futures
!Microhedging is using futures (or forwards) contracts to hedge a specific asset or liability !!basis risk is a residual risk that occurs in a hedged position because the movement in an assets
spot price is not perfectly correlated with the movement in the price of the asset delivered under a futures (or forwards) contract !!Use short positions in futures contracts to hedge an asset
that declines in value as interest rates rise !Macrohedging is hedging the entire (leverageadjusted) duration gap of an FI
Hedging Issues
! Risk-return considerations !!FIs hedge based on expected interest rate movements !!FIs may microhedge, macrohedge, or even overhedge ! Accounting rules can influence hedging
strategies !!In 1997 FASB required that all gains and losses from derivatives used to hedge must be recognized immediately !!U.S. companies must report derivative-related trading activity in
annual reports !!futures contracts are not subject to risk-based capital requirements imposed by bank regulators (forward can be)
Hedging Issues (2)
!Routine hedging: In a full hedge or routine hedge the bank eliminates all or most of its risk exposure such as interest rate risk !Most managers engage in partial hedging or what the text
terms selective hedging where some risks are reduced and others are borne by the institution
Call Options
!Buying a call option on a bond !!As interest rates fall, bond prices rise, and the call option buyer has a large profit potential !!As interest rates rise, bond prices fall, but the call option losses
are at most the call option premium !Writing a call option on a bond !!As interest rates fall, bond prices rise, and the call option writer has a large potential loss !!As interest rates rise, bond
prices fall, but the call option gains will be at most the call option premium
Put Options
!Buying a put option on a bond !!As interest rates rise, bond prices fall, and the put option buyer has a large profit potential !!As interest rates fall, bond prices rise, but the put option losses
are at most the put option premium !Writing a put option on a bond !!As interest rates rise, bond prices fall, and the put option writer has large potential losses !!As interest rates fall, bond
prices rise, but the put option gains are at most the put option premium
Option Types for Hedging
!Many types of options are used by FIs to hedge !!exchange-traded options !!over-the-counter (OTC) options !!options embedded in securities !!caps, floors, and collars
Option Types for Hedging (2)
!Buying a put option on a bond can hedge interest rate risk exposure related to bonds that are held as assets !!the put option truncates the downside losses !!the put option scales down the
upside profits, but still leaves upside profit potential !Similarly, buying a call option on a bond can hedge interest rate risk exposure related to bonds held on the liability side of the balance
sheet
Caps, Floors, and Collars
!A cap is a call option, or a succession of call options, on interest rates rather than on bond prices !!like buying insurance against an (excessive) increase in interest rates !A floor is a put
option on interest rates !!seller compensates the buyer should interest rates fall below the floor rate !!like caps, floors can have one or a succession of exercise dates !A collar amounts to a
simultaneous position in a cap and a floor !!usually involves buying a cap and selling a floor to offset cost of cap
Contingent Credit Risk
!Contingent credit risk is the risk that the counterparty defaults on payment obligations !!forward contracts and all OTC derivatives are exposed to counterparty default risk as they are
nonstandard contracts entered into bilaterally
Swaps
!Swap agreements are contracts where two parties agree to exchange a series of payments over time !There are several types of swaps: !!Interest rate swaps "!Parties agree to swap interest
payments on a stated notional principal amount for a set period of time (some are for more than 5 years) (No principal is usually exchanged) !!Currency swaps "!Parties agree to swap interest
and principal payments in different currencies at a preset exchange rate
Credit Swaps
!Credit default swaps (credit swaps) !!Total return swap (TRS): "!A TRS buyer agrees to make a fixed rate payment to the seller plus the capital gain or minus the capital loss on the underlying
instrument "!In exchange, the TRS seller may pay a variable or a fixed rate of interest to the buyer !!Pure Credit Swap (PCS): "!The swap buyer makes fixed payments to the seller and the seller
pays the swap buyer only in the event of default. The payment is usually equal to par secondary market value of the underlying instrument
Swaps and the Crisis
!Lehman Brothers and AIG sold credit default swaps worth billions of dollars in payments insuring mortgage-backed securities (MBS) ! When mortgage security values collapsed, required
outflows at these firms far exceeded capital ! Other institutions invested more heavily in MBS because they were insured; exposure to mortgage markets was more widespread than it would
have been otherwise !Credit swaps may cause lenders to make loans they would not otherwise make and earn fee income on other services offered to borrowers.
Swaps Markets
!There are also some less common types of swaps: !!commodity swaps !!equity swaps !!23 types listed in the Dodd-Frank law !The market for swaps has grown enormously in recent years
!!The notional value of swap contracts outstanding at U.S. commercial banks was more than $146.9 trillion in 2010
Interest-Rate Swap Hedging
!A money center bank (MCB) may have floating-rate loans and fixed-rate liabilities !!the MCB has a negative duration gap !A savings bank (SB) may have fixed-rate mortgages funded by
short-term liabilities such as retail deposits !!the SB has a positive duration gap
Interest-Rate Swap Hedging (2)
!Accordingly, an interest swap can be entered into between the MCB and the SB either: !!directly between the two FIs, or !!indirectly through a broker or agent who charges a fee to accept
the credit risk exposure and guarantee the cash flows !A plain vanilla swap is: !!A standard agreement where one participant pays a fixed rate of interest and the other party pays a variable
rate of interest on the same notional principal; no principal is exchanged !!thus, the SBs variable-rate inflows are now matched to its variable-rate payments
Interest-Rate Swap Hedging (3)
!SB sends fixed-rate payments to the MCB !!thus, the MCBs fixed-rate inflows are now matched to its fixed-rate payments !MCB sends variable-rate payments to the SB !!thus, the SBs
variable-rate inflows are now matched to its variable-rate payments
Currency Swap Hedging Example
!Consider a U.S. FI with fixed-rate $ denominated assets and fixed-rate denominated liabilities and a U.K. FI with fixed-rate denominated assets and fixed-rate $ denominated liabilities
!The FIs can engage in a currency swap to hedge their foreign exchange exposure !!That is, the FIs agree on a fixed exchange rate at the inception of the swap agreement for the exchange of
cash flows at some point in the future !!Both FIs have effectively hedged their foreign exchange exposure by matching the denominations of their cash flows
Credit Risk on Swaps
! The growth of the over-the-counter swap market was a major factor underlying the imposition of the BIS risk-based capital requirements !!the fear was that out-of-the-money
counterparties would have incentives to default !!BIS now requires capital to be held against interest rate, currency, and other swaps ! Credit risk on swaps differs from that on loans
!!Netting: only the difference between the fixed and the floating payment is exchanged between swap parties!!Payment flows are often interest and not principal !!Standby letters of credit are
required of poor-quality swap participantslove 37
Comparing Hedging Methods
!Writing vs. buying options !!writing options limits upside profits, but not downside losses !!buying options limits downside losses, but not upside profits !!CBs are prohibited from writing
options in some areas ! Futures vs. options hedging !!futures produce symmetric gains and losses !!options protect against losses, but do not fully reduce gains ! Swaps vs. forwards, futures,
and options !!swaps and forwards are OTC contracts, unlike options and futures !!futures are marked to market daily !!swaps can be written for longer-time horizons
Derivatives Regulation
!Regulators specify permissible activities in which FIs may engage !Institutions engaging in permissible activities are subject to regulatory oversight !Regulators judge the overall integrity of
FIs engaging in derivatives activity based on capital adequacy regulation !The Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) are the
functional regulators of derivatives securities markets
Derivatives Regulation (2)
!The Federal Reserve, the Federal Deposit Insurance Corporation (FDIC) and the Office of the Comptroller of the Currency (OCC) have implemented uniform guidelines that require banks to:
!!establish internal guidelines regarding hedging activity !!establish trading limits !!disclose large contract positions that materiallyaffect the risk to shareholders and outside investors
Derivatives Regulation (3)
!As of 2000 the FASB requires all firms to reflect the marked-to-market value of their derivatives positions in their financial statements !Prior to the Dodd-Frank Act, swap markets were
governed by relatively little regulationexcept indirectly at FIs through bank regulatory agencies !The Dodd-Frank Act of 2010 requires most OTC derivatives to be exchange-traded to ensure
performance by all parties !The act also requires OTC derivatives be regulated by the SEC and/or the CFTC
Effects of Globalization
!Todays U.S.-based companies compete and operate globally !Events and movements in foreign financial markets affect profitability and performance of U.S. firms !!Firms with only U.S.
operations face foreign competition !!For example, a U.S. resort competes with European resorts even though it has no foreign operations !!If the dollar strengthens against the euro, U.S.
resort costs increase for Europeans and can reduce the number of foreign visitors at the U.S. resortFinancial Markets and Institutions R. Sverdlove 43
Effects of Globalization Example
!Boeing sells planes to a Brazilian buyer for $15 million when the U.S. dollar is worth 2 Reals. What is the cost in Reals? !!$15 million * 2 = 30 million Reals. !If the U.S. dollar strengthens to
2.5 Reals, what is the new cost in Reals to the Brazilian buyer? !!$15 million * 2.5 Reals/$ = 37.5 million Reals !Result: If the Real has not weakened against the euro, the buyer may now be
more likely to buy planes from Airbus and pay in euros
Trade and Foreign Exchange
!Foreign trade is possible because foreign currencies can easily be exchanged !!U.S. imported $2.4 trillion of goods in 2009 !!U.S. exported $2.2 trillion of goods in 2009 !!If a country imports
more than they export, the supply of that countrys currency in the foreign exchange markets will exceed demand for the countrys currency and the value of the currency will tend to fall, all
else equal. !Internationally active firms often seek to hedge their foreign currency exposureFinancial Markets and Institutions R. Sverdlove 45
Inflation and Foreign Exchange
!A weakening $ can generate inflation in the U.S. !!Toyota sells Camrys in the U.S. for $23,000 when the exchange rate is 90 per dollar and receives 2,070,000 per car sold. !!If the dollar
weakens and is worth only 80 per dollar, how many yen will Toyota receive per car sold? !!What price would Toyota have to charge to receive the same amount of yen as before?
($23,000)(80 $) = 1,840,000 2,070,000 80/$ = $25,875 ! $25,875-$23,000 $23,000 = 12.5% price increase
Foreign Exchange Markets
!Foreign exchange markets are markets in which one currency is exchanged for another, either today (in the spot market) or at a set time in the future (in the forward market) !Foreign
exchange markets facilitate: !!foreign trade !!raising capital in foreign markets !!the transfer of risk between market participants !!speculation in currency values !A foreign exchange rate is
the price at which one currency can be exchanged for another currency
Foreign Exchange History
!Foreign exchange markets operated under the gold standard through most of the 1800s !!U.K. was the dominant international trading country until WWII forced it to deplete its gold
reserves to purchase arms and munitions from the U.S. !1944: Bretton Woods Agreement fixed exchange rates within 1% bands !1971: Smithsonian Agreement increased bands to 2 !%
!1973: Smithsonian Agreement II introduced managed free float
Foreign Exchange History (2)
!Prior to 1972, the only channel through which foreign exchange occurred was through banks !!twenty-four hours a day over-the-counter (OTC) market among major banks !!electronic
trading of spot and forward contracts !!> 90% of contracts settled by delivery of currency !Foreign exchange markets are the largest of all financial markets: trade value averaged
over $5 trillion per day in 2013.
Foreign Exchange Quotes
!Foreign exchange rates may be listed two ways !!Direct quote is U.S. dollars paid per unit of foreign currency (in US$) !!Indirect quote is foreign currency paid for each U.S. dollar (in other
currency) !Foreign exchange can involve both spot and forward transactions !!Spot transactions involve the immediate exchange of currencies at current exchange rates !!Forward
transactions involve the exchange of currencies at a specified exchange rate at a specific date in the future
Foreign Exchange Derivatives
!Organized derivatives markets have existed since 1972 !!International Money Market (IMM) (a subsidiary of the Chicago Mercantile Exchange (CME)) is based in Chicago !!trading in foreign
currency futures and options!!less than 1% of contracts are completed with delivery of the underlying currency !In 1982 the Philadelphia Stock Exchange (PHLX) became the first exchange to
offer around-the-clock trading of currency options
The Euro (")
!The European Community (EC) was formed in 1967 by consolidating three smaller communities !!European Coal and Steel Community !!European Economic Market !!European Atomic
Energy Community !The Maastricht Treaty of 1993 set the stage for the eventual creation of the Euro !!created an integrated system of European central banks overseen by a single European
Central Bank (ECB)
The Euro (") (2)
!The Euro ("), the currency of the European Union (EU), began trading on Jan 1, 1999 when eleven European countries fixed their currencies exchange ratios !Euro notes and coins began
circulating on Jan 1,2002 !The U.S. dollar depreciated against the euro in the mid-2000s, but generally strengthened during the European sovereign debt crisis !!Interest rate differentials play
a large role in euro/$ exchange rate movements except during European sovereign debt crisis
The Euro (") (3)
!The Central Bank of Russia has replaced some of its U.S. dollar reserves with euros, as has the Chinese Central Bank !In 2010, 42% of foreign exchange transactions are denominated in
dollars,compared to 19% denominated in euros
Chinese Currency
!The currency of China is officially known as renminbi, but commonly referred to as yuan, which is it primary unit. !!It is denoted by the same symbol as the Yen: !In the early 2000s the
international community pressured China to allow its currency to float freely instead of pegging it to the U.S. dollar !!Chinese exports were relatively cheap, which hurt domestic manufacturing
in other countries and Institutions R. Sverdlove 57
Chinese Currency (2)
!On July 21, 2005 the Chinese government began a policy of a limited or managed float !!The yuan is officially valued against a basket of currencies and allowed to fluctuate in a narrow
range. !!In June 2010 China promised to allow the yuan to float more freely.
Foreign Holdings of U.S. Dollars
!The largest foreign holders of U.S. dollars are China, Russia, Brazil, and India !Long term, the U.S. dollar has been depreciating due to large imports (negative balance of trade)!A lot of
Asian central bank intervention has propped up the dollars value !!Japanese Ministry of Finance increased U.S. asset purchases !!Chinese Monetary Authority bought U.S. dollar reserves, but
maintained a pegged currency !!India, Korea, and Taiwan have all attempted to limit their currencies appreciation relative to the U.S. dollar
Foreign Holdings of U.S. Dollars (2)
(all U.S. $ value but only an estimated 60% are in U.S. $) Sources: Economist, ECB and IMF Selected foreign currency reserves by country Jan 2011: Country
Foreign Currency Reserves (all in $ in billions) China $2,847 Saudi Arabia 456 Russia 444 Taiwan 382 S. Korea 292
The Dollar during the Financial Crisis
!From September 2008 to March 2009 the dollar increased in value against the major currencies as investors sought out safety in U.S. Treasury investments !From March 2009 to November
2009 the dollar began to fall as investors again sought out higher yields as fears of economic collapse subsided !Varies based on the amount of fears of investors, but generally trending
downwardarkets and Institutions R. Sverdlove 61
Foreign Exchange Risk
!Foreign exchange risk is the risk that cash flows will vary as the amount of U.S. dollars received on a foreign investment changes due to a change in foreign exchange rates !Currency
depreciation occurs when a countrys currency falls in value relative to other currencies !!domestic goods become cheaper for foreign buyers !!foreign goods become more expensive for
domestic purchasers
Foreign Exchange Risk (2)
!Currency appreciation occurs when a countrys currency rises in value relative to other currencies !!domestic goods become more expensive for foreign purchasers !!foreign goods become
cheaper for domestic buyers !The risk involved with a spot foreign exchange transaction is that the value of the foreign currency may change relative to the U.S. dollar
Foreign Exchange Risk (3)
!Foreign exchange risk can come from holding foreign assets and/or liabilities !Process of investing in a foreign country: !!convert domestic to foreign currency at spot rates
!!invest in foreign country security !!repatriate foreign investment and investment earnings at prevailing spot rates in the future
Foreign Exchange Hedging
!Firms can hedge their foreign exchange exposure either on or off the balance sheet !On-balance-sheet hedging involves matching foreign assets and liabilities !!as foreign exchange rates
move, any decreases in foreign asset values are offset by decreases in foreign liability values (and vice versa)
Foreign Exchange Hedging (2)
!Off-balance-sheet hedging involves the use of forward contracts !!forward contracts are entered into (at t = 0) that specify exchange rates to be used in the future (i.e., no matter what the
prevailing spot exchange rates are at t = 1)
Foreign Exchange Exposure
!A financial institutions overall net foreign exchange exposure in any given currency is measured as !Net exposurei = (FX assetsi FX liabilitiesi) + (FX boughti FX soldi) = net foreign assetsi
+ net FX bought = net positioni where i = ith countrys currency !A net long (short) position is a position of holding more (fewer) assets than liabilities in a given currency
Foreign Exchange Trading Activities
!A financial institutions position in foreign exchange markets generally reflects four trading activities !!purchase and sale of foreign currencies for customers international trade
transactions!!purchase and sale of foreign currencies for customers investments !!purchase and sale of foreign currencies for customers hedging !!purchase and sale of foreign currencies for
speculation (i.e., profiting through forecasting foreign exchange rates)
Purchasing Power Parity (PPP)
!Absolute PPP says that exchange rates should be such that the price of the same item is the same everywhere !!This is true for things such as securities which can be transferred
electronically and instantly !!For other assets, the time and cost of transportation comes into play. !Relative PPP explains the relationships between inflation rates and exchange rates
Purchasing Power Parity Formulas
!(Relative) purchasing power parity (PPP) theory explains the change in foreign currency exchange rates as inflation rates in the countries change !!Here we use the approximate Fisher
formula iUS = IPUS + RIRUS and iS = IPS + RIRS where i = (nominal) interest rate IP = inflation rate RIR = real interest rate US = United States S = foreign country $'"
Purchasing Power Parity
!Assuming real rates of interest are equal across countries !Finally, the PPP theorem states that the change in the exchange rate between two countries currencies is proportional to the
difference in the inflation rates in the countries IPUS ! IPS = "SUS/S / SUS/S where S US / S = the spot exchange rate of U.S. dollars per unit of foreign currency US S US S i !i = IP ! IP
Interest Rate Parity
!The interest rate parity theorem (IRPT) is thetheory that the domestic interest rate should equal the foreign interest rate minus the expected appreciation of the domestic currency
1+ iUSt = (1/ St ) ! (1+ iUKt ) ! Ft whereiUSt = the interest rate on a U.S. investment maturing at time t iUKt = the interest rate on a U.K. investment maturing at time t St = $/ spot exchange
rate at time t Ft = $/ forward exchange rate at time t $("
Interest Rate Parity Example
!Suppose U.S. interest rates are 9%, British interest rates are 11%, and the current spot rate is 1 = $1.60. According to interest rate parity, what is the equilibrium forward
rate? 1+ iUSt = (1/ St ) ! (1+ iUKt ) ! Ft 1.09 = (1/ $1.60) ! (1.11) ! Ft Ft = $1.5712
Interest Rate Parity Example 2
! Suppose U.S. interest rates are 9%, British interest rates are 11%, and the current spot rate is 1 = $1.60. How could one take advantage of this if the forward rate is actually $1.55? !
Investors would borrow pounds at 11% in the U.K., owing 1.11 pounds at year-end per pound borrowed ! Sell the pounds spot for $1.60/ and invest in the U.S. giving $1.60 x 1.09 = $1.744
! Buy the 1.11 pounds owed at the forward rate of $1.55 a pound for a dollar cost of 1.11 ($1.55/) = $1.7205 ! The net gain is $1.744 - $1.7205 = $0.0235 per pound borrowed
Balance of Payments Accounts
!Balance of payments accounts summarize all transactions between citizens of two countries !!current accounts summarize foreign trade in goods and services, net investment income,
and gifts, grants, and aid given to other countries !!capital accounts summarize capital flows into and out of a country