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Financial Markets and Institutions Mc Graw Hill 8th Edition Anthony Saunders Marcia Millon Cornett 2
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FOREIGN EXCHANGE MARKETS AND RISK: CHAPTER OVERVIEW
Cash flows from the sale of products, services, or assets denominated in a foreign currency are transacted in foreign exchange (FX) markets. A foreign exchange rate is the price at which one currency (e., the U. dollar) can be exchanged for another currency (e., the Swiss franc) in the foreign exchange markets. These transactions expose U. corporations and investors to foreign exchange risk as the cash flows are converted into and out of U. dollars. Thus, in addition to understanding the operations of domestic financial markets, financial managers and investors must also understand the operations of foreign exchange markets and foreign capital markets. Today’s U.-based companies operate globally. It is therefore essential that financial managers understand how events and movements in financial markets in other countries affect the profitability and performance of their own companies. For example, in 2019 McDon- ald’s net income was up 1 percent from 2018. However, excluding losses from foreign exchange movements, net income would have increased 5 percent. In 2019, more than 63 percent of McDonald’s revenue came from outside the United States. Most growth going forward was expected to come from business expansion overseas rather than from within the United States. Foreign currency exchange is therefore an important factor for investors LG 9- O U T L I N E Foreign Exchange Markets and Risk: Chapter Overview Background and History of Foreign Exchange Markets Foreign Exchange Rates and Transactions Foreign Exchange Rates Foreign Exchange Transactions Return and Risk of Foreign Exchange Transactions Role of Financial Institutions in Foreign Exchange Transactions Interaction of Interest Rates, Inflation, and Exchange Rates Purchasing Power Parity Interest Rate Parity Appendix 9A: Balance of Payment Accounts (available through Connect or your course instructor)
Foreign Exchange
Markets
L e a r n i n g G o a l s
LG 9-1 Understand what foreign exchange markets and foreign exchange rates are. LG 9-2 Understand the history of and current trends in foreign exchange markets. LG 9-3 Identify the world’s largest foreign exchange markets. LG 9-4 Distinguish between a spot foreign exchange transaction and a forward foreign exchange transaction. LG 9-5 Calculate return and risk on foreign exchange transactions. LG 9-6 Describe the role of financial institutions in foreign exchange transactions. LG 9-7 Identify the relations among interest rates, inflation, and exchange rates.
9
c h a p t e r
part two Securities Markets
Chapter 9 Foreign Exchange Markets 285 to consider. More broadly, extreme foreign exchange risk from a single event was evident in 2015 when banks, brokers, and individual investors lost hundreds of millions of dollars after an unexpected surge in the Swiss franc shook foreign exchange markets. The Swiss franc jumped by nearly 30 percent against the euro and 18 percent against the dollar in the minutes following the Swiss National Bank’s decision to stop capping the value of the franc against the euro. Citigroup and Deutsche Bank each lost about $150 million on the franc’s appreciation. Barclays expected losses to be in the tens of millions of dollars. FXCM Inc., a major U. retail foreign exchange broker, saw the biggest losses and had to be rescued with emergency funding of $300 million from investment firm Leucadia National Corp. An even larger event was United Kingdom’s 2016 vote to leave the European Union (called Brexit), which shocked the global economy in an unusual way. In the aftermath of the June 23 vote, the value of the British pound plummeted over 12 percent against the dol- lar and 10 percent against the euro, over the course of two weeks. The U. dollar and the Japanese yen surged. Unlike normal times, when at least one of those moves would signal faster growth to come, all three countries braced for foreign exchange risk-driven slow- downs in their economies. The United States and Japan worried that the strength of their currencies would hurt exports of their goods and services. The United Kingdom suddenly found itself in a similar situation to many developing nations, less concerned with how a weaker currency might boost its export sectors and more with the faltering economic pros- pects that caused investors to flee the pound. In 2019, U. imports of foreign goods were $2 trillion, while exports totaled $1 trillion. Trades of this magnitude would not be possible without a market where inves- tors can easily buy and sell foreign currencies. Additionally, as firms and investors increase the volume of transactions in foreign currencies, hedging foreign exchange risk has become a more important activity. Financial managers therefore must understand how events in other countries in which they operate affect cash flows received from or paid to other countries and thus their company’s profitability. Foreign exchange markets are the markets in which traders of foreign currencies transact most efficiently and at the lowest cost. As a result, foreign exchange markets facilitate foreign trade, the raising of capital in foreign markets, the transfer of risk between participants, and speculation on currency values. The actual amount of U. dollars received on a foreign transaction depends on the (for- eign) exchange rate between the U. dollar and the foreign currency when the nondollar cash flow is received (and exchanged for U. dollars) at some future date. If the foreign currency declines (or depreciates) 1 in value relative to the U. dollar over the period between the time a foreign investment is made and the time it is liquidated, the dollar value of the cash flows received will fall. If the foreign currency rises (or appreciates) in value relative to the U. dollar, the dollar value of the cash flows received on the foreign investment increases. In this chapter, we examine the operations of foreign exchange markets. We start with a brief look at the history of foreign exchange markets. We define and describe the spot and forward foreign exchange transaction process. We also look at how changes in a country’s inflation and short-term interest rates affect the exchange rate of the country’s currency. Transactions between citizens of one country (e., the United States) with other countries are summarized in the balance of payment accounts of that country. Balance of payment (international transactions) accounts for the United States are presented and described in Appendix 9A (available through Connect or your course instructor).
- Currency depreciation is most often used as the term describing the unofficial decrease in the exchange rate in a floating exchange rate system. Devaluation is a reduction in the value of a currency with respect to other monetary units. In common modern usage, it specifically implies an official lowering of the value of a country’s currency within a fixed exchange rate system, by which the monetary authority formally sets a new fixed rate with respect to a foreign reference currency. Depre- ciation and devaluation are sometimes used interchangeably, but they always refer to values in terms of other currencies.
####### foreign exchange risk
Risk that cash flows will vary as the actual amount of U. dollars received on a foreign investment changes due to a change in foreign exchange rates.
####### currency
####### depreciation
When a country’s currency falls in value relative to other currencies, meaning the country’s goods become cheaper for foreign buyers and foreign goods become more expensive for foreign sellers.
####### currency
####### appreciation
When a country’s currency rises in value relative to other currencies, meaning that the country’s goods are more expensive for foreign buyers and foreign goods are cheaper for foreign sellers.
####### foreign exchange
####### (FX) markets
Markets in which cash flows from the sale of products or assets denominated in a foreign currency are transacted.
####### foreign exchange rate
The price at which one currency can be exchanged for another currency.
BACKGROUND AND HISTORY OF FOREIGN EXCHANGE MARKETS
LG 9-2 Foreign exchange markets have existed for some time as international trade and investing have resulted in the need to exchange currencies. The type of exchange rate system used to accomplish this exchange, however, has changed over time. During most of the 1800s,
Chapter 9 Foreign Exchange Markets 287 sell their contracts prior to maturity (see Chapter 10). In contrast, delivery of the foreign cur- rency occurs on the contract’s maturity in over 90 percent of forward contracts. The foreign exchange markets have become among the largest of all financial markets, with turnover exceeding $8 trillion per day in 2019. Figure 9–1 shows the percentage share of the major foreign exchange trading centers worldwide from 1995 through 2019. London continues to be the largest center for trading in foreign exchange (43 percent of worldwide trading); it handles over twice the daily volume of New York, the second- largest market (16 percent of all trading). Despite the drawn-out Brexit process, London continues to be the dominant location for foreign exchange trading, with turnover exceed- ing $3 trillion per day in 2019. Third-ranked Singapore handles approximately one-sixth the volume of London. Moreover, the FX market is essentially a 24-hour market, mov- ing from Tokyo, London, and New York throughout the day. Therefore, fluctuations in exchange rates and thus FX trading risk exposure continues into the night even when some FI operations are closed. The Introduction of the Euro. The euro is the name of the European Union’s single currency. It started trading on January 1, 1999, when exchange rates among the curren- cies of the original 12 participating countries were fixed, although domestic currencies (e., the Italian lira and French franc) continued to circulate. By January 1, 2002, domestic currencies started to be phased out and euro notes and coins began circulating within 12 EU countries (increased to 19 EU countries and 5 non-EU countries by 2019) and Vati- can City. The eventual creation of the euro had its origins in the creation of the European Community (EC): a consolidation of three European communities in 1967 (the European Coal and Steel Community, the European Economic Market, and the European Atomic Energy Community). The emphasis of the EC was both political and economic. Its aim was to break down trade barriers within a common market and create a political union among the people of Europe. The Maastricht Treaty of 1993 set out stages for transition to an integrated monetary union among the EC participating countries, referred to as the European Monetary Union (EMU). Some of the main stipulations of the Maastricht Treaty included the eventual creation of a single currency (the euro), the creation of an integrated European system of central banks, and the establishment of a single European Central Bank (ECB). While the creation of the euro has had a significant effect throughout Europe, it has also had a notable impact on the global financial system. For example, in the first decade of the 2000s, as the United States experienced an increasing national debt, rapid con- sumer spending, and a current account deficit big enough to bankrupt most other countries LG 9- LG 9-
####### Figure 9–1 Largest Global Foreign Exchange Markets
United Kingdom United States Singapore Hong Kong Japan Daily averages in April Switzerland France 1995 1998 2001 2004 2007 2010 2013 2016 2019 Percent Note: Foreign exchange market turnover adjusted for local double-counting (i., net-gross basis). Source: BIS Statistics Explorer, stats.bis
288 Part 2 Securities Markets (see below), the euro increased in value by 35 percent against the U. dollar. Indeed, in the mid-2000s, as the dollar depreciated in value against the euro, Russia’s Central Bank said it was considering replacing some of the U. dollars in its reserves with euros. Asian central banks hinted that they would soon do the same. The Chinese Central Bank had already substituted some of its dollars for euros. As a result of these actions, the euro was the world’s second most important currency for international transactions behind the dollar and some predicted, given the combined size of the “euro-economies,” that it would com- pete against the dollar as the premier international currency. However, in the 2010s, while the U. debt problems continued, Europe was in a full-blown sovereign debt crisis. The dollar strengthened against the euro as Europe’s debt crisis continued to persist. Central banks turned back to the dollar over the euro. The dollar remains the unparalleled medium of exchange because it is the world’s easiest currency to buy or sell. In 2019, 88 percent of all foreign exchange transactions were denominated in dollars, while 32 percent were denominated in euros. Because two currencies are involved in each transaction, the sum of the percentage shares of individual currencies totals 200 percent instead of 100 percent. Dollarization. Following the abandonment of the gold standard and the Bretton Woods Agreement, some countries sought ways to promote global economic stability and hence their own prosperity. For many of these countries, currency stabilization was achieved by pegging the local currency to a major convertible currency. Other countries simply aban- doned their local currency in favor of exclusive use of the U. dollar (or another major international currency, such as the euro). The use of a foreign currency in parallel to, or instead of, the local currency is referred to as dollarization. 3 Dollarization can occur unof- ficially (when private agents prefer the foreign currency over the domestic currency) or officially (when a country adopts the foreign currency as legal tender and ceases to issue the domestic currency). For example, if the U. dollar is the currency adopted, Federal Reserve notes become legal tender and the only form of paper money recognized by the government. There is nothing to prevent a country from unilaterally moving to an official dollarized currency. However, if the U. dollar is to be used as another country’s official currency, the Fed has recommended that it receive advance notification of the extra notes that it would have to make available. The major advantage of dollarization is the promotion of fiscal discipline and thus greater financial stability and lower inflation. The biggest economies to have officially dollarized are Panama (since 1904), Ecuador (since 2000), and El Salvador (since 2001). The U. dollar, the euro, the New Zealand dollar, the Swiss franc, the Indian rupee, and the Australian dollar are the only currencies used by other countries for official dollariza- tion. Dollarization was highly unsuccessful at helping Argentina address its financial crisis in the early 2000s and was abandoned. Prior to its economic crisis from 1999 to 2002, Argentina operated under a currency board system that maintained a 1:1 exchange rate between the dollar and the peso. Dollarization required holding sufficient dollar reserves to fully back the pesos in circulation. With the appreciation of the dollar in the late 1990s, the Argentine currency board experienced overvaluation. Argentina’s exports became less competitive on the world market. In addition, Argentina had been running massive fis- cal budget deficits for some years. The climbing deficit led to an increase in devaluation concerns. As a result, roughly $20 billion in capital fled the country in 2001. Peso interest rates climbed to between 40 and 60 percent, which further weakened the government’s budget position. At the end of 2001, Argentina abandoned the peg to the dollar and went to a floating exchange rate for the peso. The Free-Floating Yuan. On July 21, 2005, the Chinese government shifted away from its currency’s (the yuan) peg to the U. dollar, stating that the value of the yuan would be determined using a “managed” floating system with reference to an unspecified basket of
####### dollarization
The use of a foreign currency in parallel to, or instead of, the local currency. 3. The term is not only applied to usage of the U. dollar, but is used generally to refer to the use of any foreign currency as the national currency.
- How the Bretton Woods Agreement affected the ability of foreign exchange rates to fluctuate freely?
- What the euro is?
D O Y O U
U N D E R S TA N D?
290 Part 2 Securities Markets It was created by the 188-country organization that works to foster global monetary coopera- tion in 1969 to support the Bretton Woods fixed exchange rate system. It is a potential claim on the freely usable currencies of its members, and SDRs can be exchanged for freely usable currencies. For China, SDR inclusion is mostly a symbolic event. It would be the first emerg- ing market currency added to the SDR and the first new currency added since the SDR’s creation. With the inclusion, China begins to enjoy the privilege of issuing a currency that is viewed not just as an invoice currency, but as a true reserve currency by its foreign partners. As of the third quarter of 2019, total foreign exchange reserves of 149 countries stood at $10 trillion, according to the IMF. The U. dollar made up 61 percent of all known foreign exchange reserves. The euro was 20 percent; Japanese yen, 5 percent; British pound sterling, 4 percent; and Chinese yuan, 2 percent.
FOREIGN EXCHANGE RATES AND TRANSACTIONS
####### Foreign Exchange Rates
As mentioned earlier, a foreign exchange rate is the price at which one currency (e., the U. dollar) can be exchanged for another currency (e., the Swiss franc). Table 9–1 lists the exchange rates between the U. dollar and other currencies as of 4:00 p. eastern standard time on March 13, 2020. Foreign exchange rates are listed in two ways: U. dol- lars received for one unit of the foreign currency exchanged (IN US$ or USD, 5 also referred to as the direct quote) and foreign currency received for each U. dollar exchanged (PER US$, also referred to as the indirect quote). For example, the exchange rate of U. dollars for Canadian dollars (CAD) on March 13, 2020, was $0 (US$/C$ or CAD/USD), or U. $0 could be received for each Canadian dollar exchanged. Conversely, the exchange rate of Canadian dollars for U. dollars was 1 (C$/US$ or USD/CAD), or 1 Canadian dollars could be received for each U. dollar exchanged. Notice that the “IN US$” exchange rates, or the rate of U. dollars for the foreign cur- rency, are simply the inverse of the “PER US$” exchange rates, or the rate of exchange of foreign currency for U. dollars and vice versa. For example, US$/C$ = $0 = 1/(C$/ US$) = 1/1, and C$/US$ = 1 = 1/(US$/C$) = 1/$0. This is the case for both spot and forward exchange rates in Table 9–1.
####### Foreign Exchange Transactions
There are two types of foreign exchange rates and foreign exchange transactions: spot and forward. Spot foreign exchange transactions involve the immediate exchange of curren- cies at the current (or spot) exchange rate—see Figure 9–2. Spot transactions can be con- ducted through the foreign exchange division of commercial banks or a nonbank foreign currency dealer. For example, a U. investor wanting to buy British pounds through a local bank on March 13, 2020, essentially has the dollars transferred from his or her bank account to the dollar account of a pound seller at a rate of $1 per 0 pound (or $1. per pound). 6 Simultaneously, pounds are transferred from the seller’s account into an account designated by the U. investor. If the dollar depreciates in value relative to the pound (e., $1 per 0 pound or $1 per pound), the value of the pound invest- ment, if converted back into U. dollars, increases. If the dollar appreciates in value rela- tive to the pound (e., $1 per 0 pound or $1 per pound), the value of the pound investment, if converted back into U. dollars, decreases. The exchange rates listed in Table 9–1 all involve the exchange of U. dollars for the foreign currency, or vice versa. Historically, the exchange of a sum of money into a differ- ent currency required a trader to first convert the money into U. dollars and then convert it into the desired currency. More recently, cross-currency trades allow currency traders to 5. USD is the currency code for the U. dollar set by the International Organization for Standardization (ISO). The ISO is an international standard-setting body composed of representatives from various national standards organizations. The ISO 4217 standard specifies the structure for a three-letter alphabetic code for the representation of currencies. The designations for the major currencies are: U. dollar (USD), euro (EUR), Japanese yen (JPY), British pound (GBP), Australian dollar (AUD), Canadian dollar (CAD), Swiss franc (CHF), and Hong Kong dollar (HKD). LG 9-
####### spot foreign exchange
####### transactions
Foreign exchange transactions involving the immediate exchange of currencies at the current (or spot) exchange rate. 6. In actual practice, settlement—exchange of currencies—occurs normally two days after a transaction.
Chapter 9 Foreign Exchange Markets 291 TABLE 9–1 Foreign Currency Exchange Rates
####### Figure 9–2 Spot versus Forward Foreign Exchange Transaction
Exchange Rate Agreed/Paid between Buyer and Seller. Spot foreign exchange transaction: Forward foreign exchange transaction: Currency Delivered by Seller to Buyer. + 0 1 2 3 Months Exchange Rate Agreed between Buyer and Seller. Buyer Pays Forward Price for Currency. Seller Delivers Currency. 0 1 2 3 Months Source: The Wall Street Journal Online, March 14, 2020, wsj Country/Currency IN US$ PER US$ Fri Thurs Fri Thurs Americas Argentina peso 0 0 62 62. Brazil real 0 0 4 4. Canada dollar 0 0 1 1. 1-month forward 0 0 1 1. 3-month forward 0 0 1 1. 6-month forward 0 0 1 1. Chile peso 0 0 839 850. Colombia peso 0 0 4023 4028. Ecuador US dollar 1 1 1 1. Mexico peso 0 0 21 21. Uruguay peso 0 0 43 43. Asia-Pacific Australian dollar 0 0 1 1. China yuan 0 0 7 7. Hong Kong dollar 0 0 7 7. India rupee 0 0 73 74. Indonesia rupiah 0 0 14770 14522 Japan yen 0 0 107 104. 1-month forward 0 0 106 105. 3-month forward 0 0 106 105. 6-month forward 0 0 106 104. Kazakhstan tenge 0 0 406 400. Macau pataca 0 0 7 8. Malaysia ringgit 0 0 4 4. New Zealand dollar 0 0 1 1. Pakistan rupee 0 0 157 159. Philippines peso 0 0 51 51. Singapore dollar 0 0 1 1. South Korea won 0 0 1211 1211. Sri Lanka rupee 0 0 184 182. Taiwan dollar 0 0 30 30. Country/Currency IN US$ PER US$ Fri Thurs Fri Thurs Thailand baht 0 0 31 31. Vietnam dong 0 0 23211 23197 Europe Bulgaria lev 0 0 1 1. Croatia kuna 0 0 6 6. Czech Rep. koruna 0 0 23 23. Denmark krone 0 0 6 6. Euro area euro 1 1 0 0. 1-month forward 1 1 0 0. 3-month forward 1 1 0 0. 6-month forward 1 1 0 0. Hungary forint 0 0 305 302. Iceland krona 0 0 135 133. Norway krone 0 0 10 10. Poland zloty 0 0 3 3. Romania leu 0 0 4 4. Russia ruble 0 0 72 74. Sweden krona 0 0 9 9. Switzerland franc 1 1 0 0. 1-month forward 1 1 0 0. 3-month forward 1 1 0 0. 6-month forward 1 1 0 0. Turkey lira 0 0 6 6. Ukraine hryvnia 0 0 26 25. U. pound 1 1 0 0. 1-month forward 1 1 0 0. 3-month forward 1 1 0 0. 6-month forward 1 1 0 0. Middle East/Africa Bahrain dinar 2 2 0 0. Egypt pound 0 0 15 15. Israel shekel 0 0 3 3. Kuwait dinar 3 3 0 0. Qatar rial 0 0 3 3. Saudia Arabia riyal 0 0 3 3. South Africa rand 0 0 16 16. Exchange Rates: New York Closing Snapshot Friday, March 13, 2020 U.-dollar foreign-exchange rates in late New York trading
Chapter 9 Foreign Exchange Markets 293 During the second phase, from March 2009 through November 2009, much of the appreciation of the dollar relative to foreign currencies was reversed as worldwide con- fidence returned. In the third phase, between November 2009 and June 2010, countries (particularly those in the euro area) began to see depreciation relative to the dollar resume (the dollar appreciated relative to the euro) amid concerns about the euro, due to prob- lems in various EU countries (such as Portugal, Ireland, Iceland, Greece, and Spain, the so-called PIIGS). From June 2010 through August 2011 worries about Europe subsided somewhat and the U. government struggled to pass legislation allowing an increase in the national debt ceiling that would allow the country to avoid a potential default on U. sovereign debt. The dollar depreciated against many foreign currencies until a debt ceil- ing increase was passed on August 2, 2011. Despite a rating downgrade on U. debt by Standard & Poor’s on August 5, 2011 (resulting from the inability of the U. Congress to stabilize the U. debt deficit situation in the long term), the dollar again appreciated relative to most foreign currencies in the period after August 2011 as fears of escalating problems in Europe, including a possible dissolution of the euro, led investors to again seek a safe haven in U. Treasury securities. In Figure 9–3, notice the lack of movement in the exchange rate between the U. dollar and the Chinese yuan between 2001 and 2005 and again between 2008 and 2010. As discussed above, during these periods the Chinese government intentionally pegged the yuan to the U. dollar. Finally, in Figure 9–3 note the increase in the exchange rate of the British pound and the euro for the U. dollar in June 2016 when the United Kingdom voted to leave the European Union. Figure 9–4 highlights these currency trends in more detail, from June 1 through mid-July 2016. On June 23, 2016, following the vote, the pound fell to its lowest level in 30 years against the dollar. Market panic was exacerbated by the news that David Cameron would be stepping down as Prime Minister. In the following weeks, the pound saw volatility as a leadership contest within the Conservative Party ensued, resulting in Theresa May taking the helm on July 13, 2016. From the Article 50 enactment of the Lis- bon Treaty to a pending Scottish Independence Referendum, the transition following the
####### Figure 9–3 Exchange Rate of the U. Dollar with Various Foreign Currencies*
. Date Date Date Date Exchange Rate Exchange Rate Exchange Rate Exchange Rate . . . . . . . . . . . USD/BRL USD/JPY USD/CNY . . . . . USD/EUR USD/AUD USD/CAD USD/GBP // // // // // // // // // ////////////////// // // // // // // // // // ////////////////// // // // // // // // // // ////////////////// // // // // // // // // // ////////////////// *Vertical axes reflect the number of foreign currency units one unit of U. dollar is worth. Source: FactSet
294 Part 2 Securities Markets Brexit vote has brought unique challenges. Article 50 of the Lisbon Treaty is the section of EU law that outlines the process for a member state to formally exit the union, and it was officially invoked by the Prime Minister Theresa May on March 29, 2017. In the immedi- ate aftermath of Article 50 being triggered, the British pound fell 0 percent against the U. dollar, extending post–Brexit Referendum losses to 17 percent. Transition dealings officially began in November 2017 with the negotiation of the “divorce bill” between the UK and EU. The divorce bill outlined a cash settlement to be paid by the UK in compensation for its share of existing EU spending commitments. In the imme- diate aftermath of the divorce bill being announced, the British pound rallied 0 percent against the U. dollar, reaching two-month highs. The price action illustrated a common theme throughout the Brexit process: any elimination of uncertainty acted as a catalyst for gains in the pound sterling. After more than three-and-a-half years of debate, negotiations, and political turmoil, the UK formally left the EU on January 31, 2020. As a result, much of the Brexit-driven political uncertainty that plagued the British pound subsided. Even though the value of the pound remained well beneath pre-2016 Brexit referendum levels, optimism toward the future boosted the British pound to yearly highs across the major currencies. A forward foreign exchange transaction is the exchange of currencies at a specified exchange rate (or forward exchange rate) at some specified date in the future, as illustrated in Figure 9–2. An example is an agreement today (at time 0) to exchange dollars for pounds at a given (forward) exchange rate three months into the future. Forward contracts are typi- cally written for one-, three-, or six-month periods, but in practice they can be written over any given length of time. Of the $6 trillion in average daily trading volume in the foreign exchange mar- kets in 2019, $1 trillion (30 percent) involved spot transactions while $4 trillion (69 percent) involved forward and other transactions. This compares to 1989 where (as shown in Table 9–2) average daily trading volume was $590 billion; $317 billion
####### forward foreign
####### exchange transaction
The exchange of currencies at a specified exchange rate (or forward exchange rate) at some specified date in the future.
####### Figure 9–4 Exchange Rate of the British Pound and Euro for the U. Dollar around
the Brexit Vote . . . . . . . // / / // // Rate Date USD/GBP USD/EUR TABLE 9–2 Foreign Exchange Market Trading (in billions of U. dollars) Sources: Bank for International Settlements, Annual Report, various dates, bis 1989 1992 1995 1998 2000 2004 2007 2010 2013 2016 2019 Total trading $590 $820 $1,190 $1,490 $1,200 $1,880 $3,210 $3,971 $5,345 $5,088 $6, Spot transactions 317 394 494 568 387 621 1,005 1,488 2,046 1,654 1, Forward and other transactions 273 426 696 922 813 1,259 2,205 2,483 3,299 3,434 4,
296 Part 2 Securities Markets been guaranteed an exchange rate of 1 U. dollars per Swiss franc, or 0 Swiss francs per U. dollar, on delivering the francs to the buyer in one month’s time. If the U. firm had sold francs one month forward at 1 on March 13, 2020, it would have largely avoided the loss of $43,800 described in Example 9–1. Specifically, by selling 3 million francs forward, it would have received: 1 × Sf 3 million = $3,150, at the end of the month, suggesting a small net loss of $3,150,600 − $3,156,300 = $5, on the combined spot and forward transactions. Essentially, by using the one-month forward contract, the U. firm hedges (or insures itself) against foreign currency risk in the spot market. As discussed below, financial institutions, and particularly commercial banks, are the main participants in the foreign exchange markets. When issuing a foreign currency– denominated liability or buying a foreign currency–denominated asset an FI will do so only if the expected return is positive.
EXAMPLE 9–2 Calculating the Return on Foreign Exchange
Transactions of a U. FI
Suppose that a U. FI has the following assets and liabilities: Assets Liabilities $81 million U. loans (one year) in dollars $162 million U. CDs (one year) in dollars $81 million equivalent UK loans (one year) in pounds The U. FI is raising all of its $162 million liabilities in dollars (one-year CDs), but it is investing 50 percent in U. dollar assets (one-year maturity loans) and 50 percent in British pound assets (one-year maturity loans). 7 In this example, the FI has matched the maturity (M) or duration (D) of its assets (A) and liabilities (L):
(MA = ML = DA = DL = 1 year)
but has mismatched the currency composition of its asset and liability portfolios. Suppose that the promised one-year U. dollars CD rate is 8 percent, to be paid in dollars at the end of the year, and that one-year, default risk–free loans in the United States are yielding 9 percent. The FI would have a positive spread of 1 percent from investing domestically. Suppose, however, that credit risk–free one-year loans are yielding 15 percent in the United Kingdom. To invest $81 million (of the $162 million in CDs issued) in one-year loans in the United Kingdom, the U. FI engages in the following transactions:
- At the beginning of the year, it sells $81 million for pounds on the spot currency markets. If the exchange rate is $1 to £1 (or GBP/USD = 1), this translates into $81 million/1 = £62 million.
- It takes the £62 million and makes one-year UK loans at a 15 percent interest rate.
- At the end of the year, pound revenue from these loans will be £62(1) = £71. million. 8
- It repatriates these funds back to the United States at the end of the year—that is, the U. FI sells the £71 million in the foreign exchange market at the spot exchange rate that exists at that time, the end of the year spot rate.
- For simplicity, we ignore the leverage or net worth aspects of the FI’s portfolio.
- No default risk is assumed.
Chapter 9 Foreign Exchange Markets 297 Suppose that the spot foreign exchange rate has not changed over the year—it remains fixed at $1/£1. Then the dollar proceeds from the UK investment are: £71 million × $1/£1 = $93 million or as a return _____________$93 million − $81 million $81 million = 15% Given this, the weighted or average return on the FI’s portfolio of investments would be: (0)(0) + (0)(0) = 0, or 12% This exceeds the cost of the FI’s CDs by 4 percent (12% – 8%). Suppose, however, that the pound had fallen (depreciated) in value against the U. dollar from $1/£1 at the beginning of the year to $1/£1 at the end of the year, when the FI needed to repatriate the principal and interest on the loan. At an exchange rate of $1/£1, the pound loan revenues at the end of the year translate into: £71 million × $1 / £1 = $84 million or as a return on the original dollar investment of: $84 − $81 $81. = 0 = 4% The weighted return on the FI’s asset portfolio would be: (0)(0) + (0)(0) = 0 = 6% In this case, the FI actually has a loss or a negative interest margin (6% – 8% = –1%) on its balance sheet investments. The reason for the loss is that the depreciation of the pound from $1 to $1 has offset the attractively high yield on British pound loans relative to domestic U. loans. If the pound had instead appreciated (risen in value) against the dollar over the year— say, to $1/£1—the U. FI would have generated a dollar return from its UK loans of: £71 million × $1 = $100 million or a percentage return of 23 percent. The U. FI would receive a double benefit from investing in the United Kingdom, a high yield on the domestic British loans and an appre- ciation in pounds over the one-year investment period. Hedging Foreign Exchange Risk. Since a manager cannot know in advance what the pound/dollar spot exchange rate will be at the end of the year, a portfolio imbalance or investment strategy in which the bank is net long $81 million in pounds (or £71. million) is risky. As we discussed, the British loans would generate a return of 23. percent if the pound appreciated from $1/£1 to $1/£1, but would produce a return of only 4 percent if the pound were to depreciate in value against the dollar to $1. Managers hedge to manage their exposure to currency risks, not to eliminate it. As in the case of interest rate risk exposure, it is not necessarily an optimal strategy to com- pletely hedge away all currency risk exposure. By its very definition, hedging reduces a firm’s risk by reducing the volatility of possible future returns. This narrowing of the probability distribution of returns reduces possible losses, but also reduces possible gains (i., it shortens both tails of the distribution). A hedge would be undesirable, therefore, if the firm wants to take a speculative position in a currency in order to benefit from some information about future currency rate movements. The hedge would reduce pos- sible gains from the speculative position. In principle, an FI can better control the scale of its FX exposure in either of two major ways: on-balance-sheet hedging and off-balance- sheet hedging. On-balance-sheet hedging involves making changes in the on-balance-sheet
Chapter 9 Foreign Exchange Markets 299 Thus, by directly matching its foreign asset and liability book, an FI can lock in a positive return or profit spread whichever direction exchange rates change over the investment period. For example, even if domestic U. banking is a relatively low-profit activity (i., there is a low spread between the return on assets and the cost of funds), the FI could be very profitable overall. Specifically, it could lock in a large positive spread—if it exists—between deposit rates and loan rates in foreign markets. In our example, a 4 percent positive spread occurred between British one-year loan rates and deposit rates compared to only a 1 percent spread domestically. Note that for such imbalances in domestic spreads and foreign spreads to continue over long periods of time, financial service firms would have to face significant barriers to entry into foreign markets. Specifically, if real and financial capital were free to move, FIs would increasingly withdraw from the U. market and reorient their operations toward the United Kingdom. Reduced competition would widen loan deposit interest spreads in the United States, and increased competition would contract UK spreads until the profit opportunities from overseas activities disappeared. If there are no real or financial barriers to international capital and goods flows, FIs can eliminate all foreign exchange rate risk exposure. Sources of foreign exchange risk exposure include international differentials in real prices, cross-country differences in the real rate of interest (perhaps, as a result of dif- ferential rates of time preference), regulatory and government intervention, and restrictions on capital movements, trade barriers, and tariffs. Hedging with Forwards. Instead of matching its $81 million foreign asset position with $81 million of foreign liabilities, the FI might have chosen to remain with a currency mis- match on the balance sheet. Instead, as a lower-cost alternative, it could hedge by taking a position in the forward or other derivative markets for foreign currencies—for example, the one-year forward market for selling pounds for dollars. Any forward position taken would not appear on the balance sheet. It would appear as a contingent off-balance-sheet claim, which we describe as an item below the bottom line in Chapter 12. The role of the forward FX con- tract is to offset the uncertainty regarding the future spot rate on pounds at the end of the one- year investment horizon. Instead of waiting until the end of the year to transfer pounds back into dollars at an unknown spot rate, the FI can enter into a contract to sell forward its expected principal and interest earnings on the loan at today’s known forward exchange rate for dollars/ pounds, with delivery of pound funds to the buyer of the forward contract taking place at the end of the year. Essentially, by selling the expected proceeds on the pound loan forward at a known (forward FX) exchange rate today, the FI removes the future spot exchange rate uncer- tainty and thus the uncertainty relating to investment returns on the British loan. or a dollar cost of funds of 19 percent. Thus, at the end of the year: Average return on assets: (0)(0) + (0)(0) = 0, or 16% Average cost of funds: (0)(0) + (0)(0) = 0, or 13% Net return: 16% − 13% = 2%
EXAMPLE 9–4 Hedging with Forwards
Consider the following transactional steps when the FI hedges its FX risk by immediately selling its expected one-year pound loan proceeds in the forward FX market:
- The U. FI sells $81 million for pounds at the spot exchange rate today and receives $81 million/1 = £62 million.
300 Part 2 Securities Markets In the preceding example, it is profitable for the FI to drop domestic U. loans and to hedge foreign UK loans, since the hedged dollar return on foreign loans of 10 percent is so much higher than the 9 percent return for domestic loans. As the FI seeks to invest more in British loans, it needs to buy more spot pounds. This drives up the spot price of pounds in dollar terms to more than $1/£1. In addition, the FI could sell more pounds forward (the proceeds of these pound loans) for dollars, driving the forward rate to below $1/£1. The outcome would widen the dollar forward–spot exchange rate difference on pounds, making forward hedged pounds investments less attractive than before. This pro- cess would continue until the U. cost of FI funds just equals the forward hedged return on British loans—that is, the FI could make no further profits by borrowing in U. dol- lars and making forward contract–hedged investments in UK loans (see also the follow- ing discussion on the interest rate parity theorem). Futures and options foreign exchange contracts, as well as foreign exchange swaps, are other derivative securities that may be used to hedge foreign exchange risk. We discuss and illustrate the use of these contracts in Chapter 24. 2. The FI then immediately lends the £62 million to a British customer at 15 percent for one year. 3. The FI also sells the expected principal and interest proceeds from the pound loan for- ward for dollars at today’s forward rate for one-year delivery. Let the current forward one-year exchange rate between dollars and pounds stand at $1/£1 or at a 5 cent discount to the spot rate; as a percentage discount:
####### ($1 − $1)/ $1 = − 3%
This means that the forward buyer of the pounds promises to pay: £62 million (1) × $1/£ = £71 million × $1/£ = $89 million to the FI (the forward seller) in one year when the FI delivers the £71 million proceeds of the loan to the forward buyer. 4. In one year, the British borrower repays the loan to the FI plus interest in pounds (£71 million). 5. The FI delivers the £71 million to the buyer of the one-year forward contract and receives the promised $89 million. Barring the pound borrower’s default on the loan or the pound forward buyer’s reneg- ing on the forward contract, the FI knows from the very beginning of the investment period that it has locked in a guaranteed return on the British loan of: $89. − $81._____________________ $81. = 0, or 10% Specifically, this return is fully hedged against any dollar/pound exchange rate changes over the one-year holding period of the loan investment. Given this return on British loans, the overall expected return on the FI’s asset portfolio is: (0)(0) + (0)(0) = 0, or 9% Since the cost of funds for the FI’s $200 million U. CDs is an assumed 8 percent, it has been able to lock in a return spread over the year of 1 percent regardless of spot exchange rate fluctuations between the initial overseas (loan) investment and repatriation of the foreign loan proceeds one year later.
302 Part 2 Securities Markets liabilities to than claims (assets) on foreigners. Thus, if the dollar depreciated relative to foreign currencies, more dollars (converted into foreign currencies) would be needed to pay off the liabilities and U. banks would experience a loss due to foreign exchange risk. However, the reverse was true in many of the most recent years (e., 2010, 2013, 2016, and 2019); that is, as the dollar appreciated relative to foreign currencies, U. banks expe- rienced a gain from their foreign exchange exposures. Table 9–5 gives the categories of foreign currency positions (or investments) of all U. banks in five major currencies in October 2019. Columns 1 and 2 of Table 9–5 refer to the assets and liabilities denominated in foreign currencies that are held in the portfolios of U. banks. Columns 3 and 4 refer to foreign currency trading activities (the spot and for- ward foreign exchange contracts bought—a long position—and sold—a short position—in each major currency). Foreign currency trading dominates direct portfolio investments. Even though the aggregate trading positions appear very large—for example, U. banks bought 715,581 billion Japanese yen—their overall or net exposure positions can be rela- tively small (e., the net position in Japanese yen was ¥21,964 billion). A financial institution’s overall net foreign exchange (FX) exposure in any given currency can be measured by its net book or position exposure, which is measured in column 5 of Table 9–5 as:
Net exposure i = (FX assets i − FX liabilities i) + (FX bought i − FX sold i)
= Net foreign assets i + Net FX bought i = Net position i Item 1993 1996 1999 2002 2004 2007 2010 2013 2016 2019 † Banks’ liabilities $78,259 $103,383 $88,537 $80,543 $ 68,189 $279,559 $167,408 $316,811 $233,941 $326, Banks’ claims (assets) 62,017 66,018 67,365 71,724 129,544 170,113 341,739 491,083 483,181 617, Claims of banks’ domestic customers* 12,854 10,978 20,826 35,923 32,056 74,693 82,123 75,608 98,621 91, Note: Data on claims exclude foreign currencies held by U. monetary authorities. Assets owned by customers of the reporting bank located in the United States that represents claims on foreigners held by reporting banks for the accounts of the domestic customers. †As of September. Sources: Treasury Bulletin, various issues, ustreas TABLE 9–4 Liabilities to and Claims on Foreigners Reported by Banks in the United States, Payable in Foreign Currencies (millions of dollars, end of period) (1) Assets (2) Liabilities (3) FX Bought (4) FX Sold* (5) Net Position† Canadian dollar 378,747 288,598 2,188,271 2,250,667 27, Japanese yen 148,295 120,671 715,581 721,241 21, Swiss franc 128,280 95,937 1,313,383 1,365,138 −19, British pounds 1,087,478 1,069,029 3,808,488 4,000,267 −173, Euro 2,397,975 2,678,012 9,113,023 9,257,687 −424, *Includes spot, future, and forward contracts. †Net position = Assets – Liabilities + FX bought – FX sold Source: Treasury Bulletin, December 2019, ustreas TABLE 9–5 Monthly U. Bank Positions in Foreign Currencies and Foreign Assets and Liabilities, October 2019 (in currency of denomination)
Chapter 9 Foreign Exchange Markets 303 where i = ith country’s currency Clearly, a financial institution could match its foreign currency assets to its liabilities in a given currency and match buys and sells in its trading book in that foreign currency to reduce its foreign exchange net exposure to zero and thus avoid foreign exchange risk. It could also offset an imbalance in its foreign asset–liability portfolio by an opposing imbal- ance in its trading book so that its net exposure position in that currency would also be zero. Notice in Table 9–5 that U. banks carried a positive net exposure position in two of the five major currencies in October 2019. A positive net exposure position implies that a U. financial institution is overall net long in a currency (i., the financial institution has purchased more foreign currency than it has sold). The institution will profit if the foreign currency appreciates in value against the U. dollar, but it also faces the risk that the for- eign currency will fall in value against the U. dollar, the domestic currency. A negative net exposure position implies that a U. financial institution is net short (i., the financial institution has sold more foreign currency than it has purchased) in a foreign currency. The institution will profit if the foreign currency depreciates in value against the U. dollar, but it faces the risk that the foreign currency will rise in value against the dollar. Thus, failure to maintain a fully balanced position in any given currency exposes a U. financial insti- tution to fluctuations in the exchange rate of that currency against the dollar. Indeed, the greater the volatility of foreign exchange rates given any net exposure position, the greater the fluctuations in value of a financial institution’s foreign exchange portfolio (see also Chapter 20, where we discuss market risk). An FI’s net position in a currency may not be completely under its own control. For example, even though an FI may feel that a particular currency will fall in value relative to the U. dollar, it may hold a positive net exposure in that currency because of many previous business loans issued to customers in that country. Thus, it is important that the FI manager recognize the potential for future foreign exchange losses and undertake hedging or risk management strategies like those described above (in Example 9–4) when making medium- and long-term decisions in nondomestic currencies. We have given the foreign exchange exposures for U. banks only, but most large nonbank financial institutions also have some foreign exchange exposure either through asset–liability holdings or currency trading. The absolute sizes of these exposures are smaller than for major U. money center banks. The reasons for this are threefold: smaller asset sizes, prudent person concerns, 9 and regulations. 10 Table 9–6 shows international versus U.-based assets held by private pension funds from 1989 to 2019. A financial institution’s position in the foreign exchange markets generally reflects four trading activities:
- The purchase and sale of foreign currencies to allow customers to partake in and complete international commercial trade transactions.
####### net long (short) in
####### a currency
A position of holding more (fewer) assets than liabilities in a given currency.
####### net exposure
A financial institution’s overall foreign exchange exposure in any given currency. 1989 1999 2004 2007 2010 2013 2016 2019 Total assets $1,631 $4,593 $4,922 $6,108 $6,143 $8,061 $8,645 $10,833. Foreign assets 137 341 267 447 443 653 721 981. U.-based assets 1,494 4,251 4,655 5,661 5,669 7,408 7,924 9,902. Sources: Board of Governors of the Federal Reserve, Flow of Funds Accounts, various issues, federalreserve TABLE 9–6 Foreign versus U.-Based Assets Held by Private Pension Funds (in billions of U. dollars) 9. Prudent person concerns, which require financial institutions to adhere to investment and lending policies, stan- dards, and procedures that a reasonable and prudent person would apply with respect to a portfolio of investments and loans to avoid undue risk of loss and obtain a reasonable return, are especially important for pension funds. 10. For example, New York State restricts foreign asset holdings of New York–based life insurance companies to less than 10 percent of their assets.
Financial Markets and Institutions Mc Graw Hill 8th Edition Anthony Saunders Marcia Millon Cornett 2
Course: Tiếng Anh 1
University: Đại học Y Dược Thành phố Hồ Chí Minh
