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Introduction 2
Foreign Currency Exposure in Australia
http://www.rba.gov.au/publications/bulletin/2017/dec/8.html
Introduction 3
Historical AUD exchange rates
AUD Exchange Rate
140.0 1.6000
1.4000
120.0
1.2000
100.0
1.0000
80.0
0.8000
60.0
0.6000
40.0
0.4000
20.0
0.2000
0.0 0.0000
Introduction 4
Overview of lecture topics
• This lecture discusses
– the measurement of foreign exchange risk to which FIs are
exposed
– the management of foreign exchange risk
– the theories of the exchange rates.
Introduction 5
Volatility of Foreign Exchange Rate
• Foreign Exchange Rate Quotes
– Direct quote: the price of the foreign currency expressed in the local
currency, example: AU$0.95 per US$
– Indirect quote: the price of the local currency in terms of the foreign
currency, example: US$1.05 per AU$
– If not explicitly specified, we will be using the direct quotes by default.
– Textbook and tutorial questions: using U.S. as the home country and
USD as the home country currency since the textbook is written by U.S.
authors, but in lecture notes and exam we will use Australia as the home
country and AUD as the home country currency
Introduction 6
Sources of Foreign Exchange Risk Exposure
• Foreign exchange risk
– 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).
FX risk exposure 7
FX exposure
8
FX risk exposure
FX exposure
• A positive net exposure implies that a FI is overall net
long in a foreign currency.
– The FI faces the risk that the foreign currency will depreciate
against the domestic currency.
9
FX risk exposure
FX exposure through foreign currency trading
FX exposure – FX trading 11
Foreign Currency Trading: Australian Dollar
(For your knowledge only)
• According to BIS (Bank for International Settlements), as at April
2007, the daily foreign exchange turnover against Australian dollars
is US$133.33 billion (US$3.98 trillion*6.7%/2).
• As at March 2010, according to RBA,
(http://www.rba.gov.au/statistics/tables/index.html#exchange_rat
es)
Turnover in millions of Composition
Currency
of instruments
AUD OTC options
swaps
6%
140000 2%
120000
100000
Outright spot
80000 24%
60000 Outright
forward
40000 4%
20000 FX swaps
64%
0
FX exposure – FX trading 12
Foreign assets and liabilities positions
FX exposure – FX asssets/liabilities 13
FX risk exposure through
foreign assets and liabilities positions
• Risk arises from mismatches between FI’s foreign
financial assets and foreign financial liabilities.
FX exposure – FX asssets/liabilities 14
Example
• Suppose an AU FI has the following assets and liabilities
Assets Liabilities
$100 million AUD loans (1- $200 million CDs (1 year)
year) (9% interest rate) in AUD, (8% interest rate).
• Exchange rate
– Spot rate at the beginning of the year $1.60/£1.
– Spot rate at the end of the year $1.45/£1.
• What is the FI’s return on the investments?
FX exposure – FX asssets/liabilities 15
Example
• End-of-year dollar amount from UK loan
– Sell $100 million for pounds at the spot exchange rate $1.60/£1.
This translates into $100/1.6=£62.5 𝑚𝑖𝑙𝑙𝑖𝑜𝑛.
– Make a one-year U.K. loan at 15% interest rate, and end of year
pound revenue is £62.5*1.15=£71.875.
– Sell the £71.875 at the spot exchange rate $1.45/£1,
£71.875*1.45=$104.22 𝑚𝑖𝑙𝑙𝑖𝑜𝑛.
FX exposure – FX asssets/liabilities 16
Hedging FX Risk
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.
Off-Balance-Sheet Hedging:
• Uses forwards, futures, or options.
• Example: hedging US$100 million foreign asset position with 1-year maturity by
taking a short position in the forward market – selling US$ for AU$ in 1 year.
Hedging 17
Example
• On-balance-sheet hedging
Assets Liabilities
$100 million AUD loans (1- $100 million CDs (1 year) in
year) (9% interest rate) AUD, (8% interest rate).
$100 million equivalent $100 million equivalent
U.K. loans (1 year) made in U.K. CDs (1 year) in pounds
pounds (15% interest rate) (11%)
Hedging 18
Example
• Off-balance-sheet hedging with forwards
– As a low cost alternative to on-balance-sheet hedging, the FI
could hedge by selling the expected one-year pound loan
proceeds in the forward FX market at today’s known forward
exchange rate, say, $1.55/£1.
– This removes the uncertainty regarding the future spot rate on
pounds at the end of the one-year investment horizon and thus
the uncertainty relating to the return on the British loan.
Assets Liabilities
$100 million AUD loans (1- $200 million CDs (1 year)
year) (9% interest rate) in AUD, (8% interest rate)
$100 million equivalent
U.K. loans (1 year) made in
pounds (15% interest rate)
Hedging 19
Example
• End-of-year dollar amount from UK loan, when hedging
with forwards
– Sell $100 million for pounds at the spot exchange rate $1.60/£1.
This translates into $100/1.6=£62.5 𝑚𝑖𝑙𝑙𝑖𝑜𝑛.
– Make a one-year U.K. loan at 15% interest rate, and end of year
pound revenue is £62.5*1.15=£71.875.
– Sell the £71.875 at the pre-agreed forward rate $1.55/£1,
£71.875*1.55=$111.41 𝑚𝑖𝑙𝑙𝑖𝑜𝑛.
Hedging 20
Theories on foreign exchange rate
• Purchasing power parity theorem
FX pricing 21
Purchasing Power Parity (PPP)
• The exchange rate should be determined based on the
purchasing power of currencies.
– The concept is founded on the law of one price, that is, in
absence of transaction costs, identical goods will have the same
price in different markets.
• Absolute PPP Theory: A theory on the level of exchange
rates
– Domestic and foreign currencies should have the same
purchasing power after adjusting for exchange rate – i.e., being
able to purchase the same amount of goods and services
– 1 $F / Price$F = S$D / Price$D
– Hence, Exchange Rate ($D/$F) = S = Price$D / Price$F
– Example, The Economist’s Big Mac Index
(http://www.economist.com/content/big-mac-index)
– Assumption of perfect arbitrage for goods and services, which is
problematic
FX pricing 22
Purchasing Power Parity (PPP)
• Relative PPP Theory: A theory on the movement in
exchange rates
– PPP theory may not hold for the level of exchange rate, but may
hold for the change.
– The change in exchange rate should reflect the change in the
relative purchasing powers of currencies, which is the difference
in inflation rates
FX pricing 25
Interest Rate Parity Theorem (IRPT)
• Hence IRPT states that the spread between domestic and
foreign interest rates equals the percentage spread
between forward and spot exchange rates.
▪ (1+rD) = (1/ S0)*(1+rF)*F => 1+rD = (1+rF)*F / S0
▪ (1+rD)/ (1+rF) = F/ S0 => (rD-rF)/ (1+rF) = (F- S0)/ S0
▪ Where S0 and F are spot and forward exchange rate in direct quote.
▪ Since 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.
FX pricing 26
Interest Rate Parity Theorem: Application
• 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?
FX pricing 27
Interest Rate Parity Theorem: Application
• 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).
– It also means that € is undervalued in the spot market (relative
to the forward market)
– 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 0.62 > current spot rate (0.6).
So € is relatively undervalued in the spot market, which means $
is relatively overvalued.
FX pricing 28
Interest Rate Parity Theorem: Application
• How to design arbitrage trading strategy based on the information above?
– Since the actual forward rate is higher than the IRPT-implied forward
rate, the arbitrage trading strategy should involve selling € at the
forward rate (short € in the forward market).
– To cover your obligation to deliver € under the short forward contract,
you have to buy € in the spot market.
– So a complete trading strategy is:
1) sell one € at the forward rate 0.59, which costs you nothing now,
but you are expected to deliver one € and receive 0.59 $ in one
year
2) buy 1/(1+10%) = 1/1.1 € in the spot market and invest the amount
in the foreign market at 10% for one year, which costs you
(1/1.1*0.6) $ now, and yields 1 € in one year
3) borrow 0.59/(1+5%) = (0.59/1.05)$ now in the domestic market
at 5% interest rate for one year, which gives you (0.59/1.05)$
now, but you are expected to pay 0.59$ in one year
4) Cash flows: a) at time 0, (0.59/1.05) - (1/1.1*0.6) = $ 0.01645; b)
at time 1, 0.
FX pricing 29
Uncovered Interest Rate Parity Theorem
• Recall the trading strategy to derive IRPT
– Invest in domestic government securities, where the return is guaranteed
as (1+rD)
– Invest in foreign government securities and guarantee a domestic
currency return of (1/ S0)*(1+rF)*F with short forward contract.
– The derived IRPT theory: (rD-rF)/(1+rF) = (F- S0)/ S0 , is called as Covered
IRPT theorem, because both legs produce certain returns.
FX pricing 30
Uncovered Interest Rate Parity Theorem
• If you don’t hedge the foreign exchange risk in the foreign market investment:
• the return is (1/ S0)*(1+rF)*S1. where S1 is the spot exchange rate in one
year and uncertain.
• Since domestic investment return is certain and foreign one is not, the
returns of two investment strategies are not necessarily equal (subject to
exchange rate movement).
• But on average, they should be roughly equal: (1+rD) ~= (1/ S0)*(1+rF)* S1
• Hence we can derive a slightly different version of IRPT
(rD-rF)/(1+rF) ~= (S1 - S0)/ S0
• The same implication holds here: a relatively higher domestic interest rate
indicates that domestic currency is expected to depreciate in the future.
• This version of IRPT is called as Uncovered IRPT.
• In this lecture, IRPT refers to the Covered version.
FX pricing 31