Practical limits of foreign exchange
September 24th, 2009
There are practical limits on how far forward it is possible to hedge a foreign exchange exposure using forwards, futures or swaps. Banks do not usually try to hedge equity positions they hold in foreign subsidiaries where the position is effectively perpetual. This limit also depends on the depth and liquidity of the currency markets. For major currencies the practical limit is in the region of three to seven years. For exposures in minor currencies and in particular those of developing countries the ability to hedge may be very limited.
Banks in developing markets are exposed to particular risks associated with managed currency systems. When interest rates on foreign currency loans are lower than rates on local currency loans borrowers may be tempted to take out foreign currency loans. When exchange rates are floating this offers no real benefit as the borrower also takes the risk of exchange rate movements. If the borrower hedges this exposure interest rate parity ensures that there is then no benefit to the borrower of taking a foreign currency loan.
Under managed currency systems the central bank provides a form of guarantee of future rates. If the local currency is pegged against the foreign currency then banks may be tempted to borrow in the foreign currency and lend these on. Superficially at least it has a flat FX position and is not exposed to changes in exchange rates. This is a fallacy. It faces three specific risks. The first is the potential impact on its capital adequacy ratios, the second is the transformation of exchange risk into credit risk and the third its transformation into liquidity risk:
Impact on capital adequacy ratios. If the foreign currency appreciates against the local currency and it is fully hedged the value of its assets and liabilities will both increase by the same amount. Its equity base, however, is in local currency terms. As the value of its foreign currency assets rises its capital adequacy ratio (in approximate terms equity divided by assets) will fall. If a bank has material levels of foreign loans and there is a sharp devaluation its capital adequacy ratio may fall below regulatory requirements.
Transformation into credit risk. Although the bank is hedged its borrowers who have taken foreign currency loans are not. A devaluation of the local currency will increase the value of foreign currency debt and increase the cost of servicing that debt in local currency terms.
These two effects result in a much higher risk of default.
Transformation into liquidity risk. When a bank has funded foreign currency loans with short-term foreign funding it is exposed to the risk of a flight of funds. Foreign lenders to the banks may decide not roll to over their deposits to the bank when they reach term. Local borrowers with long-term foreign currency loans will not be able to repay their loans quickly. A bank may not be able to attract foreign currency deposits at all (because of credit concerns) and if it does so it may have to pay punitive rates. If it is able to pass those higher rates onto borrowers then this will further increase default risk.
Filed under: Foreign exchange