Finance 510 - Exam 4
FI engage in 2 types of FX transactions in which they act as the agent but take on no risk themselves
-in support of customers positions in foreign real and financial investments -in support of international commercial trade transactions
law of one price
in competitive markets free of transportation costs and barriers to trade, identical products sold in different countries must sell for the same price when their price is expressed in the same currency
an exchange rate quote that gives the cost of one US dollar in foreign currency is called a
indirect quote
general macroeconomic risks such as increases _____, _______ and _____ can directly and indirectly impact an FIs level of interest rate, credit, and liquidity risk exposure
inflation; inflation volatility; unemployment
An FI is exposed to _____ when the maturities of its assets and liabilities are mismatched and interest rates are volatile
interest rate risk
spot foreign exchange transactions
involve the immediate exchange of currencies at current exchange rates -can be conducted through the foreign exchange division of commercial banks or a nonbank foreign currency dealer -the risk involved is that the value of the foreign currency may change relative to the US dollar over a holding period
foreign exchange risk
is introduced by adding foreign currency assets and liabilities to a firms B/S - like domestic assets and liabilities returns result from the contractual income from or costs paid on a security
an important element for the credit risk management process for FIs is properly _________ their loans
pricing
maturity matching may reduce an FIs exposure to interest rate risk but it may also reduce its
profitability
when an Fi funds its long term assets with S-T liabilities it must periodically _________ its liabilities to continue funding the assets
refinance
sudden changes in __________ related to lending or to entry or on products offered are a form of discrete risk to FIs
regulatory policy
when an FI funds it ST assets with LT liabilities it must periodically _____ its liabilities as the assets mature
reinvest
the risk that the interest rate that can be earned on S-T assets will be less than the interest rate paid on the L-T liabilities is called
reinvestment risk
electronic trading platforms automatically provide traders with ______ gathered from _________
the best prices available; multiple dealers
Fisher effect
the one-for-one adjustment of the nominal interest rate to the inflation rate -currency of a country with higher interest rates will depreciate relative to the currency of a country with lower interest rates
on June 23, 2016 following the UK vote to leave the European. union.....
the pound fell to its lowest level in 30 years against the dollar
foreign exchange rate
the price at which one currency can be exchanged for another currency
interest rate risk
the risk incurred by an FI when the maturities of its assets and liabilities are mismatched and interest rates are volatile -mismatching maturities by holding longer term assets than liabilities means that when interest rates rise, the economic or PV of the FIs assets falls by a larger amount than its liabilities-- FIs can seek to hedge themselves against risk by matching maturities -rising interest rates increase the discount rate on future asset (liability) cash flows and reduce the market price or present value of that asset or liability---- conversely falling interest rates increase the PV of of CFs
market risk
the risk incurred in trading assets and liabilities due to changes in interest rates, exchange rates, and other asset prices - closely related to interest rate and FX risk -market risk adds another dimension of risk : trading activity
Systemic Credit Risk
the risk of default associated with economywide or macroconditions affecting all borrowers ex: an economic recession
firm-specific credit risk
the risk of default for the borrowing firm associated with the specific types of project risk taken by that firm
Liquidity Risk
the risk that a sudden and unexpected increase in liability withdrawals may require an FI to liquidate assets in a very short period of time and at low prices -arises when an FIs liability holders such as depositors, or insurance policy holders demand immediate cash or when holders of off balance sheet loan commitments suddenly exercise their right to borrow -the FI must either liquidate assets or borrow additional cash -day to day withdrawals by liability holders is not generally a problem
letter of credit
A credit guarantee issued by an FI for a fee on which payment is contingent on some future event occurring. -this is an example of an off BS activity -many state and local governments could not issue such securities without bank or insurance company letter of credit guarantees that promise principal and interest payments to investors should the municipality default on its obligations in the future- thus it guarantees payment should a municipal government face financial problems in paying on the bond it issues
net exposure
A financial institution's overall foreign exchange exposure in any given currency
1992 12 major European countries and Vatican City pegged their exchange rates together to create a single currency
Called the Euro- it started trading on January 1, 1999
foreign exchange risk
Risk that cash flows will vary as the actual amount of U.S. dollars received on a foreign investment changes due to a change in foreign exchange rates
forward contracts are typically written for periods of 6 months or less, but can be written for any time period
TRUE
true or false: country or sovereign risk may be caused by the actions of a foreign government that affect the business environment in that country
TRUE
FIs cannot be asset transformers (transforming S-T deposits into long-term loans) AND direct BS matchers or hedgers at the same time
TRUE -as a result some FIs emphasize asset- liability maturity mismatching more than others
flight to quality
The action of investors moving their capital away from riskier investments to the safest possible investment vehicles.
Purchasing Power Parity (PPP)
The amount of money needed in one country to purchase the same goods and services in another country -theory that describes how the exchange rate between 2 countries will adjust due to differences in inflation between the two countries
forward foreign exchange transaction
The exchange of currencies at a specified exchange rate (or forward exchange rate) at some specified date in the future in 2016 67.5 percent involved forward contracts
during the period of 2003- 2007 the US dollar _________ against the euro and most other major currencies as well
depreciated -a main factor affecting exchange rate movements was interest rate differentials across major economies -the second factor affecting the exchange rates was a high volume of central bank intervention relative to past practice -these actions kept upward pressure on the local currencies but helped devalue the US dollar
for a currency governed by a fixed exchange rate system, the official reduction in value of that currency by the governments monetary authority is called
devaluation
___________ arises because of excess capacity, redundant technology and or organizational and bureaucratic inefficiencies that become worse as an FI grows in size
diseconomies of scale
a key assumption underlying Purchasing Power parity is that real risk-free interest rates are _______ across countries
equal
following the brexit vote the______ also depreciated against the dollar due to the uncertainty of the impact of the brexit on the _________economy
euro ;euro zone
Fixed coupon bonds (credit risk)
financial claim issued with risk-return trade off - in event of default the FI earns zero interest on the asset and may well lose all of part of the principal lent, depending on its ability to lay claim to some of the borrowers assets through legal bankruptcy and insolvency proceedings
diversification reduces ________ credit risk while still leaving the FI exposed to ________ credit risk
firm-specific, systemic
a firm can reduce its net exposure in a currency to zero by offsetting an imbalance in its ________ with an opposing imbalance in its _______
foreign asset-liability portfolio; FX trading book
Off balance sheet assets and liabilities affect the _______ of the FIs BS rather than the ______
future state; current state
major structural change for FX trading
growing share of electronic brokerage in the interbank markets at the expense of direct dealing (and telecommunication)
The creation of the Euro
had its orgins in the creation of the EC: a consolidation of three European communities in 1967 (the European coal and steel community, the European economic market, and the European atomic energy community) -aim was to break down trade barriers within a common market and create a political union among the people of Europe
managers use ______ to manage their exposure to currency risk not to eliminate it
hedges -as in the case of interest rate risk exposure, it is not necessarily an optimal strategy to completely hedge away all currency risk exposure -hedging reduces a firms risk by reducing the volatility of possible future returns -reduces possible losses and gains
the investment portfolio contains assets and liabilities that are relativley _____ and are held for ____ periods
illiquid; longer
spot transactions can be conducted through, _________ or ___________
commercial banks; non-bank currency dealers
the major players in foreign currency trading and dealing are the large _______ and ________ banks
commercial; money center
trading portfolio
contains assets, liabilities, and derivative contracts that can be quickly bought and sold on organized financial markets
trading book
contains long and short positions in instruments such as bonds, commodities, FX, equities and derivatives
foreign exchange market is the largest of all financial markets
daily turnover exceeding 4.8 trillion per day in 2015
The Free Floating Yuan
-prior to July 2005 the Chinese yuan was pegged to the US dollar meaning that the yuan-to-dollar exchange rate was fixed -July 21, 2005 the Chinese government shifted away from it currency the (yuan) to the US dollar stating that the value of the yuan would be determined using a "managed" floating system with reference to an unspecified basket of foreign currencies -the partial free floating yuan was a result of pressure from western countries who argued that chinas currency gave it unfair advantage in global markets due to relative underpricing of the yuan with respect to the the dollar and other currencies- the undervaluation resulted in Chinese exports being relatively cheap, which hurt domestic manufacturing in other countries -in 2009 it began a pilot program of internationalizing its currency by allowing Hong Kong banks to trade the yuan- it went from less than 100 billion yuan to 600 billion yuan in 2013 -January 2011- china began allowing Americans to trade in the currency and Chinese based companies were allowed to use yuan for business outside the mainland --In 2013 the CME announced it would join Hong Kong Exchanges and Clearing Limited and start trading Chinese Renmimbi (CNH) futures under contracts of up to three years
The Smithsonian agreement II (1973)
-the exchange rate boundaries were eliminated altogether -allowed exchange rates of major currencies to float freely -this free floating is still partially in place, however central governments may still intervene in the foreign exchange markets directly to change the direction of exchange rates and currency movements by altering interest rates to affect the value of their currency relative to others -the exchange rate boundaries were eliminated and the exchange rates of the major currencies were allowed to float freely
FI's position in the foreign exchange markets reflects four
1. the purchase and sale of foreign currencies to allow customers to partake in and complete international commercial trade transactions 2. the purchase and sale of foreign currencies to allow customers (or the FI itself) to take positions in foreign real and financial investments 3. the purchase and sale of foreign currencies for hedging purposes to offset customer (or FI) exposure in any given currency 4.the purchase and sale of foreign currencies for speculative purposes through forecasting or anticipating future movements in foreign exchange rates
London is the largest center for trading in foreign exchange
37.1 percent of world wide trading - handles twice the daily volume of New York the second largest market at 19.4 percent, third ranked is Singapore -however UK voted to leave the European Union and this may affect London as the dominant location
Other Risks that can impact FIs profitability and risk exposure
Discrete risk: sudden change in taxation, such as tax reform act of 1986 Changes in regulatory policy: lifting the regulatory barriers to lending or to entry or on products offered, ex: the 1999 financial services modernization act, 2010 wall street reform and consumer protection act -Other event risks such as theft, malfeasance, breach of fiduciary trust -General macroeconomic risks such as increased inflation, inflation volatility, unemployment- these can directly and indirectly impact FIs level of interest rate, credit, and liquidity risk exposure
asset transformation
FI buying primary securities or assets and issuing secondary securities or liabilities
the risk that exchange rate changes can adversely affect the value of an FIs assets and liabilities denominated in foreign countries is called
FX risk
During the 1800s foreign exchange market operated under a gold standard or system
This means currency issuers guaranteed to redeem notes, upon demand, in an equivalent amount of gold -governments that employed such a fixed system of exchange, and redeemed their notes to other governments in gold shared a FIXED CURRENCY relationship -gold became transportable, universal, amd a stable unit of valuation -during 1939-1942 the UK depleted much of its gold stock in purchases of munitions and weaponry from the US and other nations to fight WW2 this led to the Bretton Woods Agreement
three companies that dominate the market for the provision of electronic trading platforms, software, and FX quotation systems
Thomas Reuters, BATS global markets, and ICAPS EBS
foreign exchange risk
US pension funds held 5 percent of their assets in foreign securities but since have changed to close to 13 percent and many large banks have gone global -FIs can reduce risk through domestic foreign activity/ investment diversification -return on foreign direct investments and portfolio investments are different because the underlying technologies of various economies differ and exchange rate may be appreciating while the dollar-yen exchange rate may be depreciating
Foreign Exchange Market
a market in which cash flows from the sale of products or assets denominated in a foreign currency are transacted -markets in which traders of foreign currencies transact most efficiently and at the lowest cost -foreign exchange markets facilitate foreign trade, the raising of capital in foreign markets, the transfer of risk between participants, and speculation on currency values -essentially a 24 hour market moving from Tokyo, London and New York throughout the day, therefore fluctuations in exchange rates and thus FX trading risk exposure continues into the night even when some FI operations are closed
Net long in a currency
a position of holding more (fewer) assets than liabilities in a given currency
net short
a position of holding more (fewer) assets than liabilities in a given currency
interest rate parity
a situation in which the rates of return on assets in different currencies are equal
cross currency
allows traders to bypass this step of initially converting into US dollars -pair of currencies traded in foreign exchange markets that do not involve the US dollar
a firm that is net long in a currency will profit if that currency _______ against the dollar, and will lose if that currency _______ against the dollar
appreciates; depreciates
contingent assets and liabilities
assets and liabilities off the balance sheet that potentially can produce positive or negative future cash flows for an FI
during the financial crisis the dollar appreciated sharply against most foreign currencies
between 2008-2010 -phase 1: from 2008 Sep -2009 March the US dollar appreciated relative to most foreign currencies as investors sought a safe haven in US treasury securities
any forward position taken would not appear on the B/S
it would appear as contingent off balance sheet claim -the role of the forward FX contract is to offset the uncertainty regarding the future spot rate on pounds at the end of the one-year investment horizon -the FI can enter into a contract to sell forward its expected principle and interest earning on the loan at todays known forward exchange rate for dollars/pounds with delivery of pound funds to the buyer of the forward contract taking place at the end of the year -this removes future spot exchange rate uncertainty
FIs that fund ________ assets with ________ liabilities will find that when interest rates rise, the value of their assets ________ by a larger amount than their liabilities
long-term; short-term; falls
foreign exchange markets are the markets in which traders of foreign currencies transact _______ and ________
most efficiently and at the lowest cost
Euro
name of the european unions single currency- started trading on January 1st, 1999 - exchange rates among the currencies of the original 12 participating countries were fixed although domestic currencies (the Italian lira and French franc) continued to circulate -by Jan 1, 2002, domestic currencies started to be phased out and euro notes and euro coins began circulating with 12 EU countries (increased to 22 EU countries by 2013) and Vatican city
FI could offset an imbalance in its foreign asset liability portfolio by an opposing imbalance in its trading book so that its _________ position in that currency would also be zero
net exposure
a firms overall exposure to foreign exchange risk in any currency can be measured by its _______ in that currency
net exposure
a firms net exposure to a foreign currency is the sum of its _______ and its _______ in that currency
net foreign assets; net FX bought
a positive net exposure position implies that a US financial institution is overall _________
net long in a currency
a negative net exposure position implies that a US FI is _______ in a foreign currency
net short
a foreign currency forward contract is a ________ hedge
off balance sheet
the failure of the market to adequately assess the risk of _____ contributed to the severity of the losses of FIs during the financial crisis
off balance sheet securities
Off-Balance Sheet Risk
risk incurred by an FI as the result of activities related to contingent assets and liabilities -large banks invest heavily in off balance sheet assets and liabilities particularly derivative securities -an off BS activity- does not appear on an FIs current BS since it does not involve holding a current primary claim (asset) or the issuance of a current secondary claim (liability)----- instead these activities affect the future shape of an FIs balance sheet -the ability to earn fee income while not loading up or expanding the BS has become an important motivation for FIs to pursue off BS business, however it is not risk free -off BS securities played a bug part in US subprime mortgage crisis----- MBS and CMO were based on misleading information of creditworthiness of borrowers
Maastricht Treaty of 1993
set out stages for transition to an integrated monetary union among the EC participating countries, referred to as the EMU -eventual creation of single currency -creation of integrated European system of central banks -establishment of single European Central Bank (ECB)
two types of foreign exchange rates
spot and forward
sudden changes in ______ can affect the attractiveness of some types of assets over others, as well as the liquidity of an FIs BS
taxation
online trading portals
terminals where currency transactions are being executed - low cost way of conducting spot and forward foreign exchange transactions w
The Bretton Woods Agreement
the 1944 decision to establish a global currency system with the U.S. dollar pegged at a fixed rate of exchange to gold, and the currencies of 43 other countries fixed to the dollar - this led to some currencies such as the US dollar to become overvalued and other such as the German mark to become undervalued - this led to the Smithsonian Agreement of 1971
The Smithsonian Agreement
the 1971 decision allowing the United States to devalue the dollar against other countries' currencies, thereby beginning the breakdown of the 1944 Bretton Woods Agreement - the boundaries between which exchange rates could fluctuate were increased for 1 percent to 2 1/4 percent
Insolvency Risk
the risk that an FI may not have enough capital to offset a sudden decline in the value of its assets relative to its liabilities -can be an outcome of one or more of the risks including: interest rate, market, credit, off BS, technological, FX, sovereign, and liquidity -occurs when the capital or equity resources of an FIs owners are driven to, or near to, zero due to losses incurred as a result of one of those risks - the more equity capital to borrowed funds an FI has the lower the leverage the better it is to withstand losses due to risk exposures such as adverse liquidity changes, unexpected credit losses, and so on. -thus both the management and regulators of FIs focus on an FIs capital as a key measure of its ability to remain solvent and grow in the face of risk exposure
Operational risk
the risk that existing technology, auditing, monitoring, and other support systems may malfunction or break down -operational risk is not exclusively the result of technological breakdown. Other sources of operational risk can result in direct costs, indirect costs, and opportunity costs that reduce an FIs profitability and market value
Country or Sovereign Risk
the risk that repayments from foreign borrowers may be interrupted because of interference from foreign governments -the country in which the company is located may prohibit or limit debt repayment due to foreign currency shortages and adverse political events -thus sovereign risk is a broader measure of the risk faced by the FIs that operate abroad -you can measure this risk by analysis of macroeconomics issues such as trade policy, the fiscal stance of the government, government intervention in the economy, monetary policy, capital flows and foreign investment, inflation and structure of Financial system `
refinancing risk
the risk that the cost of rolling over or reborrowing funds will rise above the returns being earned on asset investments -good example of this is mid 2010s as banks borrowed short-term deposits (deposits whose interest rates change)
Price Risk or market value uncertainty
the risk that the price of the security will change when interest rates change
credit risk
the risk that the promised cash flows from loans and securities held by FIs may not be paid in full -All types of FIs face this risk -loans with longer maturities are more exposed to risk so depository institutions and life insurers are more exposed to credit risk than money market mutual funds -key role of FIs involve screening and monitoring loan applicants to ensure they are creditworthy - continue to give out loans even though it may be risky because the FI charges a rate of interest on a loan that compensates for the risk of the loan -FIs have advantages over individual investors bc they are able to diversify credit risk exposures from a single asset by exploiting the law of large numbers in their asset investment portfolios (diversification)
Reinvestment Risk
the risk that the returns on funds to be reinvested will fall below the cost of funds
At times FIs face a liquidity crisis
this can happen from lack of confidence in an FI or some unexpected need for cash that may lead to higher demand for withdrawals -when all or many FIs face abnormally large cash demands, the cost of purchased or borrowed funds rises and the supply of such funds becomes restricted----- as a consequence FIs may have to sell some of their less liquid assets to meet the withdrawal demands of liability holders -the liquidation of some assets at low or "fire sale" prices (the price the FI receives if the assets must be liquidated immediately at less than fair market value) could threaten an FIs solvency and profitability -ex: Indymac bank failed and had to be saved by FDIC
the daily volume of foreign exchange transactions can be measured in
trillions of dollars
Dollarization
use of foreign currency (often U.S. dollars) as money instead of the local currency -this can occur unofficially (when private agents prefer the foreign currency over the domestic currency) or officially (when a country adopts the foreign currency as legal tender and ceases to issue the domestic currency) -The US dollar, the euro, the New Zealand dollar, the Swiss franc, the Indian rupee, and the Australian dollar are the only currencies used by other countries for official dollarization -major advantage is the promotion of fiscal discipline and thus greater financial stability and lower inflation -the biggest economies to have officially dollarized are Panama (since 1904), Ecuador (since 2000), and El Salvador (since 2001)
currency depreciates
when a countries currency falls in value relative to other currencies meaning the countries good become cheaper for foreign buyers and foreign goods become more expensive for foreign sellers -in value relative to the US dollar over the period between the time a foreign investment is made and the time it is liquidated, the dollar value of the cash flows received will fall
currency appreciation
when a countries currency rises in value relative to other currencies, meaning that the countries goods are more expensive for foreign buyers and foreign goods are cheaper for foreign sellers -in value relative to the US dollar, the dollar value of the cash flows received on the foreign investment increases
