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P1.T3. Markets & Products

Bionic Turtle FRM Practice Questions Reading 15

Saunders, Financial Institutions Management:

A Risk Management Approach

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SAUNDERS, CHAPTER 14: FOREIGN EXCHANGE RISK .................................................................. 3 P1.T3.191. FOREIGN EXCHANGE EXPOSURE ............................................................................................. 3 P1.T3.192. FOREIGN EXCHANGE (FX) EXPOSURE ..................................................................................... 6 P1.T3.193. ON- AND OFF-BALANCE-SHEET FOREIGN EXCHANGE (FX) RISK HEDGES ...................................... 9 P1.T3.194. INTEREST RATE PARITY ........................................................................................................ 14

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Saunders, Chapter 14: Foreign Exchange Risk

P1.T3.191. Foreign exchange exposure

AIMs: Calculate a financial institution’s overall foreign exchange exposure. Demonstrate how a financial institution could alter its net position exposure to reduce foreign exchange risk.

191.1. The spot foreign currency exchange rate is EUR/USD $1.4296/$1.4304. Each of the following is true about this quote except:

a) The spread is 8 pips b) If the domestic currency is the US dollar (USD), from the perspective of an American

trader, as EUR is the base currency and the USD is the quoted currency, this is direct quote

c) We can buy one Euro for $1.4304 and sell one Euro for $1.4296 d) If the spot rate changes to EUR/USD $1.4416/$1.4424, then the EUR has weakened

and the USD has strengthened 191.2. Since the start of 2011, the spot foreign currency exchange rate between the U.S. dollar and Euro has moved from about EUR/USD $1.30 to about EUR/USD $1.43 (EUR/USD = base/quoted currencies). Which of the following is TRUE?

a) American goods are cheaper to European buyers (benefiting US exporters) b) American goods are more expensive to European buyers (hurting US exporters) c) European manufacturers benefit in American markets as their goods become

cheaper to American buyers d) Interest rate parity and arbitrage tend to approximately nullify the impact of the

currency exchange rates on even un-hedged importers and exporters

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191.3. A U.S. bank holds portfolios denominated in Swiss francs as follows: CHF 10.0 billion in assets and CHF 12.0 billion in liabilities. With regard to the bank’s trading activities, they have bought and sold the following (i.e., spot, futures and forward contracts): bought CHF 3.0 billion and sold CHF 2.0 billion. What is the bank’s net exposure to Swiss francs (CHF)?

a) CHF -3 billion net exposure b) CHF -1 billion net exposure c) zero net exposure d) CHF +1 billion net exposure

191.4. A Japanese bank (whose domestic currency is the yen, JPY) has the following positions in US dollars: $5.0 billion in assets, $3.0 billion in liabilities, $2.5 billion USD bought and $5.7 billion USD sold. The bank is unhedged with respect to its USD exposure. If the exchange rate moves from USD/JPY 80.0000 to USD/JPY 72.0000, what is the impact on the bank?

a) The bank incurs losses on the US dollar depreciation (vis a vis the yen) b) The bank earns profits on the US dollar depreciation c) The bank incurs losses on the US dollar appreciation d) The bank earns profits on the US dollar appreciation

191.5. A US bank has the following pound sterling exposures: GBP 10.0 billion in assets, GBP 7.0 billion in liabilities, GBP 5.0 billion bought, GBP 6.0 billion sold. The bank is concerned that the pound sterling will fall in value relative to the US dollar. Which of the following will reduce the bank’s exposure to pound sterling depreciation?

a) Nothing, its net exposure implies a benefit if GBP depreciates b) Add +2 billion in assets to the balance sheet that are denominated in pound sterlings c) Add +2 billion in liabilities to the balance sheet that are denominated in pound

sterlings d) Add + 2 billion in long forward exposure to the pound sterling; i.e., promises to buy

GBP in the future

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Answers:

191.1. D. To go from able to buy one Euro for $1.4304 to able to buy one Euro for $1.4424, we need more dollars to buy one Euro, so the dollar has weakened (similarly, one Euro gets us more dollars than before). In regard to (A), (B) and (C), each is true. Please note EUR/USD refers to base/quoted currency, such that EUR/USD $1.4296 means $1.4296 dollars [ie, the quoted currency] per 1 Euro [ie, the base currency]. 191.2. A. American goods are cheaper to European buyers (benefiting US exporters) 191.3. B. CHF -1 billion net exposure Net exposure = (FX assets - FX liabilities) + (FX bought - FX sold). In this case, (CHF assets - CHF liabilities) + (CHF bought - CHF sold) = (10 - 12) + (3 - 2) = -2 + 1 = CHF - 1 billion net exposure 191.4. B. The bank earns profits on the US dollar depreciation In moving from USD/JPY 80.0000 to USD/JPY 72.0000, the US dollar is the base currency and it weakens (while the yen strengthens; it takes fewer yen to buy one dollar). The Japanese bank is NET SHORT the US dollar: (5-3) + (2.5 - 5.7) = -1.2 USD net exposure. If the bank is net short the foreign currency, it faces the risk that the dollar will rise; conversely, it profits from the dollar weakening. 191.5. C. Add +2 billion in liabilities to the balance sheet that are denominated in pound sterlings The net exposure = (10 - 7) + (5 - 6) = +2 GBP; i.e., the bank is net long pound sterling and faces the risk of GBP depreciation. Each of answers (A), (B) and (D), increase the net long exposure to a greater net long exposure. Discuss in forum here: http://www.bionicturtle.com/forum/threads/l1-t3-191-foreign-exchange-exposure.4680/

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P1.T3.192. Foreign Exchange (FX) exposure

AIMs: Calculate a financial institution’s potential dollar gain or loss exposure to a particular currency. List and describe the different types of foreign exchange trading activities. Identify the sources of foreign exchange trading gains and losses.

192.1. A bank has a EUR 2.0 million trading position in spot Euros. The spot EUR/USD exchange rate is $1.40 (EUR is the base currency and USD is the quote currency). The daily volatility of the EUR/USD exchange rate is 34 basis points (bps). If the bank assumes the exchange rate volatility is normally distributed, what is the 95% confident daily earnings at risk (DEAR) of the position in US DOLLAR terms; i.e., the 95% dollar VaR due only to foreign exchange (FX) exposure?

a) $7,997 b) $11,185 c) $15,659 d) $28,642

192.2. According to Saunders, which of the following is LEAST likely to minimize a bank’s foreign exchange exposure?

a) Match assets and liabilities in a given currency b) Match purchases and sales in a given currency c) Purchase sovereign credit default swaps (CDS) d) Aggregate foreign exchange exposures across businesses in a holding company

192.3. According to Saunders, which of the four trading activities most contributes to foreign exchange (FX) risk exposure?

a) Open positions in a currency b) Purchase and sale of currencies for hedging purposes c) Purchase and sale of currencies to complete international transactions. d) Facilitating positions in foreign real and financial investments

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192.4. A French company manufactures and sells products in and for the EU market. The company sources input components from Switzerland, paying the invoices for these inputs in Swiss francs (CHF). What is French company’s currency risk and how can it hedge? (note: modified version of handbook example 11.4).

a) CHF appreciation against EUR; sell CHF against buying EUR forward b) CHF appreciation against EUR; sell EUR against buying CHF forward c) CHF depreciation against EUR; sell CHF against buying EUR forward d) CHF depreciation against EUR; sell EUR against buying CHF forward

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Answers:

192.1. C. $15,659 Dollar value of the position = 2.0 million EUR * $1.4 USD per EUR = $2.8 million FX VaR = 1.645 * 34 bps = 55.93 bps DEAR = $2.8 million * 0.0056 ~= $15,659 192.2. C. While a sovereign CDS might provide an indirect hedge via a spread trade, this is the least direct; FX exposure is firstly a market risk, not a credit risk. In regard to (A), (B) and (C), these are true as the three methods given by Saunders. 192.3. A. Open positions in a currency In regard to (C) and (D), please note Saunders says here, “the bank [FI] normally acts as an agent of its customers for a fee but does not assume the FX risk itself.” 192.4. B. CHF appreciation against EUR; sell EUR against buying CHF forward The company earns revenues in EUR but has some costs in CHF. It will be hurt if the CHF appreciates against the EUR. The hedge is to buy the CHF forward. Discuss in forum here: http://www.bionicturtle.com/forum/threads/l1-t3-192-foreign-exchange-fx-exposure.4692/

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P1.T3.193. On- and off-balance-sheet foreign exchange (FX) risk hedges

AIMs: Calculate the potential gain or loss from a foreign currency denominated investment. Explain balance-sheet hedging with forwards.

193.1. A U.S. bank raises USD $200 million in liabilities that pay a domestic (USD) interest rate of 4.0%, in order to fund two investments:

$100 million invested into U.S. dollar denominated assets, and The remaining $100 million invested into Euro (EUR) denominated assets.

The expected net (of default risk) yield on the USD assets is 6.0% and the net yield on the EUR assets is 8.0%. In this way the expected return on the investment (ROI) is 3.0% as the difference between the blended ROA of 7.0% (average of 6.0% and 8.0%) and the cost of funds (COF) of 4.0%. However, the bank is un-hedged with respect to currency risk. At the beginning of the year, the exchange rate is EUR/USD $1.40. At the end of the year, the exchange rate has moved to EUR/USD $1.26. The nominal returns for the year were exactly as expected. What is the one-year realized ROI if we account for the currency shift? Note: please assume all interest rates are effective annual rates (EARs), consistent with Saunders' illustrations in the assigned readings. For example, an effective annual rate of 8.0% is equivalent to 8.0% per annum with (discrete) annual compounding.

a) ROI of +5.90% because the EUR appreciated against the USD b) ROI of -4.30% because the EUR appreciated against the USD c) ROI of +1.90% because the EUR depreciated against the USD d) ROI of -2.40% because the EUR depreciated against the USD

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193.2. Assume the same bank as in the previous question: the bank invests USD $100 million in assets to yield 6.0% and EUR 100 million to yield 8.0%. However, in the case, the bank employs an on-balance-sheet hedge. Consequently, it borrows USD $100 million paying 4.0% and borrows EUR 100 million also paying 4.0%. This on-balance-sheet hedge matches the EUR 100 million invested abroad by funding with EUR 100 million. At the beginning of the year, the exchange rate is EUR/USD $1.40 which moves to EUR/USD $1.26 by the end of the year. What is the bank's ROI given it has employed this on-balance-sheet hedge?

a) ROI -0.40% (losses contained) b) ROI about zero (per the hedge) c) ROI +2.80% d) ROI +4.56%

193.3. Which of the following is true about the use of an ON-BALANCE-SHEET HEDGE to control a bank’s foreign exchange (FX) exposure?

a) The hedge will lock-in (guarantee) a specific, predetermined net return b) The hedge can ensure a positive, but nevertheless volatile, net return c) The hedge cannot ensure a positive net return d) By employing a forward foreign currency contract, the on-balance-sheet hedge can

ensure a positive return that is also not volatile 193.4. A Swiss bank raises CHF 200 million Swiss francs (liabilities) in order to fund half into a domestic investment (asset) of CHF 100 million and the rest in Eurozone investment (asset in EUR). What is the Swiss bank’s un-hedged currency risk and how could the Swiss bank manage this exposure with an OFF-BALANCE-SHEET hedge?

a) Risk is depreciation of the Swiss franc against the Euro; off-balance-sheet hedge is sell forward (deliver) EUR in exchange for receiving CHF

b) Risk is deprecation of the Swiss franc against the Euro; off-balance-sheet hedge is sell forward (deliver) CHF in exchange for receiving EUR

c) Risk is appreciation of the Swiss franc against the Euro; off-balance-sheet hedge is sell forward (deliver) EUR in exchange for receiving CHF

d) Risk is appreciation of the Swiss franc against the Euro; off-balance-sheet hedge is sell forward (deliver) CHF in exchange for receiving EUR

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Answers:

Spreadsheet here @ https://www.dropbox.com/s/nn2sv7gjds27mha/T3.193.%20fx%20hedges.xlsx 193.1. D. ROI of -2.40% because the EUR depreciated against the USD Please note, in EUR/USD $1.40, EUR is the base currency and USD is the quote currency. (Confusing because, as a fraction, this is really $1.40 USD per 1 EUR.) A move to EUR/USD $1.26 is an appreciation of USD against EUR and a depreciation of the EUR against the dollar; i.e., the same one EUR is buying fewer dollars, or it takes fewer dollars to buy one EUR. In regard to $100 MM invested in EUR:

Start of year: USD $100 MM is converted into USD 100 * EUR 0.7143/USD = EUR 71.43;

End of year: EUR 71.43 MM grows to EUR 71.43*(1+8.0%) = EUR 77.14 MM; But 77.14 MM is converted back to USD at the depreciated EUR: 77.14 * USD

1.26/EUR = $97.20; Return on this half of the investment is only -2.80% The blended ROA is then (+6% - 2.4%)/2 = 1.60%, and Given a COF of 4.0%, the ROI is -2.4%.

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193.2. C. ROI +2.80% After accounting for depreciation of EUR, as above, the ROA is only 1.60%; i.e., the asset returns remain hurt by the EUR depreciation. But depreciation on the liabilities more than offsets the borrowing cost: the blended COF is -1.20%; i.e., the bank profits on the liabilities side. The ROI is 2.80%. Note: as with Saunders' example, this is in the vicinity of the 3.0% spread expected under a stable currency (it's a little lower due to the rate differential between assets and liabilities).

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193.3. B. The hedge can ensure a positive, but nevertheless volatile, net return As illustrated by the examples, the hedge ensure directional protection and the net return will tend to cluster near the net return earned under a scenario of: un-hedged with no currency changes. However, due to the spread differentials, volatility will remain. Please note (D) is non-sensical. 193.4. C. Risk is appreciation of the Swiss franc against the Euro; off-balance-sheet hedge is sell forward EUR in exchange for receiving CHF The un-hedged bank will be hurt by depreciation of the Euro (as it has EUR 100 million invested in assets, the bank is LONG the EUR). If un-hedged, in the future, depreciated Euros will purchase (convert) back to fewer Swiss francs; the bank hedges this by selling forward those expected Euros and “locking in” the net receipt of future francs. Discuss in forum here: http://www.bionicturtle.com/forum/threads/l1-t3-193-on-and-off-balance-sheet-foreign-exchange-fx-risk-hedges.4696/

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P1.T3.194. Interest rate parity

AIMs: Describe the relationship between nominal and real interest rates. Describe how a non-arbitrage assumption in the foreign exchange markets leads to the interest rate parity theorem; use this theorem to calculate forward foreign exchange rates. Explain why diversification in multicurrency asset-liability positions could reduce portfolio risk.

194.1. A US bank raises USD $10 million (liabilities) and invests this amount into a Russian project denominated in Russian rubles (asset) with an expected foreign rate of return of 12%. The bank remains unhedged with respect to this currency risk. If there is an sudden increase in the Russian inflation rate, without any corresponding impact on the project’s nominal, foreign 12% return on the project, according to purchasing power parity (PPP), what is the impact on the bank?

a) No impact b) Ruble should appreciate, translating into a gain for the bank c) Ruble should depreciate, translating into a gain for the bank d) Ruble should depreciate, translating into a loss for the bank

194.2. The current spot exchange rate between the Euro and the U.S. dollar is EUR/USD $1.40 (base/quote). Relative inflation rates shift from parity such that the inflation rate in the Eurozone is 2.0% but inflation rate in the United States is 4.0%. According to purchasing power parity (PPP), what should be the impact on the exchange rate?

a) The Euro will depreciate by $0.0510 to EUR/USD $1.4510 b) The Euro will depreciate by $0.0510 to EUR/USD $1.3490 c) The Euro will appreciate by $0.0280 to EUR/USD $1.4280 d) The Euro will appreciate by $0.0280 to EUR/USD $1.3720

194.3. The spot exchange rate EUR/USD is $1.40. The 18-month forward exchange rate is EUR/USD $1.35. If the short-term US interest rate is flat at 1.00%, what is the 18-month Eurozone interest rate implied by (covered) interest rate parity (IRP) if we assume continuous compounding? As a bonus, solve also under an assumption of (discrete) annual compounding.

a) 0.87% b) 1.45% c) 2.38% d) 3.42%

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194.4. The spot exchange rate EUR/CHF is CHF 1.20. Interest rates are flat at 2.0% in the Eurozone (EUR) and 5.0% in Switzerland (CHF). According to interest rate parity (IRP), what should be the 12-month EUR/CHF forward exchange rate if we assume annual (discrete) compounding?

a) EUR/CHF 1.14 b) EUR/CHF 1.20 c) EUR/CHF 1.24 d) EUR/CHF 1.28

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Answers:

194.1. D. Ruble should depreciate, translating into a loss for the bank As the bank is net invested in ruble-denominated assets, the bank is long the Russian ruble. Per PPP, inflation in Russia should lead to depreciation of the Russian ruble, which will create a loss on the long currency position. 194.2. C. The Euro will appreciate by $0.0280 to EUR/USD $1.4280 Change in spot FX rate = Initial spot FX rate * (inflation_quote_currency - inflation_base_currency). In this case, Change in spot FX rate = EUR/USD $1.40 * (4% - 2%) = +$0.280, such that new spot rate should be $1.40 + $0.028 = EUR/USD $1.4280; i.e., appreciation of the (base currency) Euro. 194.3. D. 3.42% (continuous compounding) Continuous compounding: Spot*exp(rate_domestic*T) = Forward*exp(rate_foreign*T), such that: rate_foreign = LN[Spot*exp(rate_domestic*T)/Forward]*1/T = LN[1.40*exp(1%*1.5)/1.35]*1/1.5 = 3.4245%. In the same way, we can use the cost of carry (!) model: Forward = Spot * exp[(rate_domestic - rate_foreign)*T], such that: rate_foreign = rate_domestic - LN(Forward/spot)*1/T = 1.0% - LN(1.35/1.40)*1/1.5 = 3.4245% Annual compounding: Spot (1+rate_domestic)^T = Forward*(1+rate_foreign)^T, such that: rate_foreign = [Spot * (1+rate_domestic)^T/Forward]^(1/T) - 1. In this case, rate (EUR) = [1.40*(1.01)^1.5/1.35]^(1/1.5) - 1 = 3.478% 194.4. C. EUR/CHF 1.24 Spot * (1+rate_domestic)^T = Forward*(1+rate_foreign)^T, and Forward = Spot* (1+rate_domestic)^T/(1+rate_foreign)^T, and Forward (EUR/CHF) = Spot (EUR/CHF) * (1+CHF rate)^T/(1+EUR)^T, and Forward (EUR/CHF) = 1.20 * 1.05/1.02 = EUR/CHF 1.2353 Discuss in forum here: http://www.bionicturtle.com/forum/threads/l1-t3-194-interest-rate-parity.4701/