Foreign Exchange Exposure
Net exposure in a foreign currency measures the extent to which a bank is net long or net short a foreign currency. A financial institution’s net currency exposure is calculated as:
net currency exposure = (currency assets − currency liabilities) + (currency bought − currency sold)
A net long (short) position in a currency means that a bank faces the risk that the FX rate will fall (rise) in value versus the domestic currency.
Reduce Exchange Risk
A financial institution could reduce its foreign exchange exposure by altering either or both components of the net position exposure equation. For example, to reduce its exposure to zero, it could:
- Match its foreign currency assets to its liabilities on the balance sheet (the first component would be equal to zero) and match its long and short trading positions in the currency (the second component would be zero).
- Be long the currency in one component and short the currency in the other component so the two positions offset.
The Effect Of An Appreciation/Depreciation
For a change in an exchange rate, we can calculate the percentage appreciation (price goes up) or depreciation (price goes down) of the base currency. For example, a decrease in the USD/EUR exchange rate from 1.44 to 1.42 represents a depreciation of the EUR relative to the USD of 1.39% (1.42 / 1.44 – 1 = –0.0139) because the price of a euro has fallen 1.39%.
Potential Dollar Gain Or Loss Exposure
The potential gain/loss exposure to a foreign currency is a function of the size of the position and the potential change in the value of the foreign currency:
dollar gain/loss in EUR = net EUR exposure (measured in $) × % change in the $/FC rate
If a financial institution fails to maintain a balanced position, the institution will be exposed to variations in the FX rate. The more volatile the FX rate, the more potential impact a net exposure (either long or short) will have on the value of a bank’s foreign currency portfolio.
Foreign Trading Activities
A financial institution’s buying and selling of foreign currencies, and hence the institution’s position in the FX market, reflects four key trading activities:
- Enabling customers to participate in international commercial business transactions.
- Enabling customers (or the financial institution itself) to take positions in real and financial foreign investments.
- Offsetting exposure in a given currency for hedging purposes.
- Speculating on future FX rate movements.
Foreign Asset And Liability Positions
Most of the profits and losses on FX come from speculation or open position taking. A secondary source of revenue comes from market-making activities and/or agency fees.
Returns for the bank’s portfolio are derived from differences between income and costs. However, there is an extra dimension of return and risk from adding foreign currency assets and liabilities to a portfolio.
On-Balance-Sheet Hedging
There are two principle methods of better controlling the impact of FX exposure:
- On-balance-sheet hedging is achieved when a financial institution has a matched maturity and foreign currency balance sheet.
- Off-balance-sheet hedging occurs through the purchase of forwards for institutions that choose to remain unhedged on the balance sheet.
Interest Rate Parity (IRP)
Interest rate parity (IRP) suggests that the discounted spread between domestic and foreign interest rates equals the percentage spread between forward and spot exchange rates. IRP can be stated using continuously compounded rates as follows:
forward rate = spot rate × e(rDC− rFC)T
Purchasing Power Parity
Purchasing power parity (PPP) states that changes in exchange rates should exactly offset the price effects of any inflation differential between the two countries. The equation for PPP is as follows:
%ΔS(domestic/foreign) = inflation(domestic) – inflation(foreign)
Diversification
Since domestic and foreign interest rates and stock returns are not perfectly positively correlated, opportunities for potential gains from asset-liability portfolio diversification can offset currency risk.
Relationship Between Nominal And Real Interest Rates
The real interest rate reflects a given currency’s real demand and supply for its funds. The nominal interest rate is the compounded sum of the real interest rate and the expected rate of inflation over an estimation horizon. To the extent global markets aren’t perfectly integrated, foreign exchange rates are positively but not perfectly positively correlated, and there are risk-reduction benefits from holding multicurrency portfolios.
