money-drained

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.

MANAGING CURRENCY RISK

Transactional currency risk can be hedged tactically or strategically by the corporate Treasury to preserve cash flow and earnings, depending on their currency view.
Translational currency risk is usually hedged opportunistically rather than systematically, notably to try to avoid emerging market-related shocks to net assets, usually focusing on either long-term foreign investment or debt structure.
Hedging economic risk is complex, requiring the corporation to forecast its revenue and cost streams over a given period and then to analyse the potential impact on these of an exchange rate deviation from the rate used in calculating revenue and cost. For the debt structure, the currency of denomination must be chosen, the amount of debt estimated in that currency and the average interest period determined. The effect on cash flow should be netted out over product lines and across markets. What’s left from this process is the economic risk that has to be managed. For large multinationals, the net economic risk may in fact be quite small because of offsetting effects. However, economic risk can be substantial for corporations that have invested in only one or two foreign markets.
The first two steps of this process appear to have been accomplished. Firstly, we have defined very specifically the types of currency risk that a corporation is exposed to. Secondly, we have looked at broad strategy, the brushstrokes of managing that currency risk. Yet, while this currency risk may be defined, it must also be quantified. Quantifying an amount of currency may be easy for transaction risk, but for translation or economic risk it is no easy task. Just as with other types of risk management, the most popular way of doing this is to use a “VaR” model.

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