Foreign Exchange Risk
7 important questions on Foreign Exchange Risk
What are sources of foreign exchange risk exposure?
- Liabilities
- Contracts bought (long)
- Contracts sold (short)
Overall net exposure = (FX Assets - FX Liabilities) + (FX Bought - FX Sold).
It could also offset an imbalance in its foreign asset-liability portfolio by and opposing imbalance in its trading book so that its net exposure position in that currency would be zero.
Net long in a currency or net short in a foreign currency (later has the risk that the foreign currency could rise in value).
What about FX volatility and exposure?
If demand is high and supply low a currency will appreciate in value.
Foreign asset and liability positions?
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How about hedging FX?
- on balance sheet hedging (restoring mismatch)
- off balance sheet hedging (take positions in forwards to hedge FX risk on cashflows)
What about on-balance sheet hedging?
What about using forwards, off-balance sheet hedging?
How does it work? Sell forward its expected principal and interest earnings on the loan at today's known forward exchange rate. By this the bank removes the future spot exchange rate uncertainty (FX risk).
What about multicurrency foreign asset-liability positions?
Theoretically speaking, nominal interest rate has two components;
- Real interest rate (reflects underlying real sector demand and supply for funds in that currency)
- Expected inflation (lenders demand from borrowers to compensate for the erosion in the principal or real value of the funds they lend.
In general correlations tend to increase during crisis.
The question on the page originate from the summary of the following study material:
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