Aug 21

Foreign Exchange. 2007 FRM: FX Intro

by David Harper, CFA, FRM, CIPM

FRM | Risk |

introFX

Learning Outcomes

  • LO 19.1 Describe the different sources of foreign exchange risk exposure
  • LO 19.2 Explain the different types of foreign trading activities……and explain the sources of most profits and losses on foreign exchange trading
  • LO 19.3 Describe foreign exchange exposure resulting from mismatches between foreign financial asset and liability portfolios, and explain how returns and risks of foreign investing can impact returns

Sources of Foreign Exchange (FX) Risk Exposure

Foreign exchange exposure is a function of portfolio positions (i.e., assets and liabilities denominated in foreign currencies) and trading activities (i.e., contracts bought and sold on the spot and forward foreign exchange markets). A bank's overall foreign exchange (FX) exposure is measured by its net position exposure (where i = ith currency):

 Net exposurei = (FX assetsi - FX liabilitiesi) + (FX boughti - FX soldi)
  = Net foreign assetsi + Net FX boughti

The net exposure can be either:

  • Net long in a currency: the risk is that the foreign currency will fall in value against our domestic currency
  • Net short in a currency: the risk is that the foreign currency will increase in value against our domestic currency

According to Saunders, although foreign currency levels have increased in recent years, trading volume has decreased for the following reasons: 

  • Investment bank mergers has reduced the number of traders.
  • Technology increased the efficiency of foreign exchange traders.
  • Due to the introduction of the Euro (January 2002), the cross-trading of member currencies within the EMU bloc has been eliminated.

Four Foreign Exchange (FX) Trading Activities

The four trading activities (LO 19.2) are the purchase or sale of foreign currencies...

  1. To allow customers to participate in international commercial trade transactions
  2. To allow customers to take positions in foreign investments (real or financial assets)
  3. For hedging purposes—i.e., to offset currency exposure
  4. For speculative purposes

Profitability of Foreign Currency Trading

Most profits or losses on foreign trading come from taking an open position or speculation in currencies. Revenues from market making—the bid-ask spread—or from acting as agents for retail or wholesale customers generally provide only a secondary or supplementary revenue source.

Foreign Asset and Liability Positions

The idea here is: without a hedge foreign current assets and liabilities add another layer of risk and return. For example, a U.S. bank may hold $200 in assets and $200 liabilities (as claims on the assets, of course). Say the bank decides to invest one-half of its assets into foreign currency assets. It still holds $200 in assets and liabilities and the durations may even be same, but it has a currency mismatch. 

Assets Liabilities
$100 million, US Loans, US Dollars $200 million U.S. Dollars
$100 million equivalent, Foreign Loans, Foreign Dollars  

 

The return on the foreign currency asset (loan) will be impacted by the change in the spot foreign exchange rate over the period. If the foreign currency falls in value (vis-a-vis the dollar), or the U. S. dollar appreciates in value (vis-a-vis the foreign currency), the net returns will be eroded by this currency impact. I will show a model of this next...

 

Sources:

Comments

  1. Be the first to leave a comment!

Leave a Comment