Short-term Positions
When a bank has, or owes, a foreign currency it has a potential foreign exchange risk. Short- term outright exposures may arise directly from holding a foreign currency, for example. Retail customers can usually obtain relatively small amounts in cash of a major foreign currency from larger branches in major cities or at international airports. For larger amounts it is always necessary to give some notice. In the overall scheme of things these exposures are not material. Most short-term positions are due either to banks’ trading operations or arise out of services provided by the bank to customers to facilitate trade financing.
A bank with an outright spot position can hedge that position by entering into a forward contract. Let us take the following case. A US bank has a cash position of ¥100bn, the current ¥:$ exchange rate is 100, 90-day annualized ¥ interest rates are 2% and 90-day annualized US interest rates are 3%. The bank can hedge its position by entering into a forward contract to sell ¥1005bn into US$ in three months’ time. The current 90-day forward rate is 99.7519.
This works as follows. Our ¥ cash position will earn ¥5bn in interest over the 90 days. We can fund this by borrowing $1000m on which we will pay interest of $7.5m. When we convert the ¥1005bn at 99.7519 we will receive $1007.5m allowing us to repay our US$ loan plus interest due on the loan.
The above assumes, of course, that we can enter into a forward contract at an exchange rate of 99.7519. It turns out that given the interest rates in the two currencies this is exactly the level that the forward rate will take. This is due to the effects of arbitrage and we will look at arbitrage in detail in the following two chapters on trading and the management of market risk. In brief, arbitrage ensures that spot and forward exchange rates adjust in response to changing interest rates in the currencies concerned to ensure that no risk-free profit can be made from the following combination of transactions:
A bank borrows in one currency, lends in another for a fixed term and enters into a forward contract to convert the proceeds from the loan back into the currency borrowed.
The bank will make a profit if the proceeds from the exercise of the forward contract are greater than the amount we borrowed to finance the transaction.
August 12th, 2009